The allure of making money without any active participation is a dream of many but a reality for only a few. Some people are very good at generating passive income but have you wondered how is passive income taxed?
We take a look at some types of passive income and how taxation works for this kind of income generation. We'll also consider the difference between passive and active income taxation.
In easy to understand language passive income is money that you earn through little or no effort on your part.
According to the IRS passive income can be "net rental income" or "income from a business in which the taxpayer does not materially participate".
Passive income can also include self charged interest, high yield savings accounts, interest on stocks and bonds in a brokerage account and affiliate marketing.
Although the generation of passive income doesn't require any physical activity on the part of the person receiving it, it does require an upfront investment of time or money and more usually, both.
Let's take a look at some of the different types of passive income.
The list of passive income opportunities noted here is not exhaustive but gives an idea of the kind of income streams that can be generated without material participation.
A popular method of generating passive income is affiliate marketing. This involves entering into a partnership with a larger enterprise and promoting its goods or services.
Someone with a website or blog in a particular niche has a ready made marketing platform for a target audience. If someone purchases something through the affiliate marketer they receive a commission.
If an affiliate marketer earns less than $600 in a tax year then they do not have to pay any tax on this passive income.
When they earn more than $600 they should be issued with a 1099-NEC form by the company who pays them.
This form reports all payments made during the tax year to the affiliate marketer by someone who is not their employer. The form is for the benefit of the IRS and in some states for their taxing authorities.
Income from rental properties is counted as passive income unless you are a real estate professional. It also doesn't qualify as passive income if you are renting a space you own to a business in which you are an active participant.
The only exemption to this is if the lease was signed before 1988 in which case the income can be considered passive.
Self-charged interest is another type of passive income. This type of interest occurs if you lend money to your own business. The loan interest that you pay to yourself is considered passive income.
High Yield Savings Accounts
Putting your money into high yield savings accounts is an obvious method of generating passive income.
The downside is that the amount of interest will be relatively minor, and your money may be tied up in a savings account rather than other investment strategies.
Passive Income And Taxation
Passive income is taxed as it is still generating money even if it is doing so passively. The way and amount that it is taxed will depend on the source of the passive income and how much money is being generated.
If you rent out a part of your home or a separate rental property for more than 14 days in a year this income is taxable.
Rental income is taxed as ordinary income, however you are allowed to deduct your mortgage interest as well as some other deductions such as depreciation.
If you have invested in ordinary dividends then the passive income from this investment will be taxed as ordinary income.
REITs (Real Estate Investment Trusts) and ETFs (Exchange Traded Funds) that invest in master limited partnerships pay these types of dividends.
On the other hand, if your passive income is coming from qualified dividends then the tax you pay will be capital gains tax.
High Yield Savings Account
The interest you earn from a high yield savings account will be taxed at your marginal income tax rate.
But only after appropriate deductions have been made. If you earn interest of $10 or more your bank will send a 1099-INT form for you to fill out.
If you generate income from investments in tax-advantaged accounts then you will pay no tax. These accounts include 401(k)s, IRAs as well as the Roth equivalent of each. If you use an online brokerage account you will be liable for taxes.
Business Investment Income
If you invest capital in a business but have no material or active part in its management then this is considered passive income. The interest and ordinary dividends from such investment will be taxed at your ordinary income rate.
Passive Income Versus Active Income
The difference between passive income and active income is the level of participation in the generation of the income.
One is actively achieved while the other is generated without material participation. Taxation for both is different too.
Active or ordinary income is taxable according to where it falls in the seven tax brackets. These range from 10% at the lower range to 37% in the highest bracket.
Passive income is taxed along the lines of capital gains rules. This ranges from 0% to 20% and is useful for protecting your income from excessive taxation compared to ordinary income.
Some passive income is completely tax free such as the interest on municipal bonds. In this case federal tax cannot be applied to the interest payments
Passive income is becoming a goal for many people with various income streams available via different sources.
However, the taxation of each type of passive income generation needs to be fully and properly understood before committing yourself.
We hope this guide to how passive income is taxed has been helpful to you.
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