How is Passive Income Taxed?

Lidia Staron, author at OpenLoans
Lidia Staron   Head of Content
Personal Finance
I enjoy navigating people through important financial decisions.

In this day and age, earning a salary is not always enough to get by. Fortunately, there are plenty of ways to generate extra cash flow. And one of the best ways to do that is through passive income. This way, you can focus on your current job and still earn enough to keep up with the monthly bills. Maybe you can even set aside money for a rainy day.

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Whether or not you've settled on a way to make that extra money, there's one little thing that you shouldn't forget — paying your taxes. While you've probably already mastered how to pay taxes on your regular income, you should know that passive income taxes are a whole other matter. It's not only the passive income tax rate that's different. The income levels at which those rates increase are also different.  

What is Passive Income?

What is passive income?

Before we get into the nitty-gritty of calculating your passive income taxes, let's first correctly define what passive income is so that we're all on the same page. Most, if not all of us, have heard about this before. It is one of the best tools for establishing financial wellness. But not all of us have a clear understanding of what it is and how it is different from other types of income.

According to Wikipedia, passive income is income that does not require much effort from a person to earn money and maintain it. According to the IRS, passive income is when you make money from rental property or a business without being actively involved. For example, you're the silent partner or an investor in the business.

If we want to be more technical about it, the IRS explains "actively involved" as when you work more than 500 hours in a year on the project from which you're profiting. It can also be when you've worked at least 100 hours on a project, equal to at least one other person involved in the activity.

As we've already mentioned, there are other types of income. Just to be clear, earned income is your salary, bonuses, tips, commissions, and net gains from being employed or self-employed. Another type of income is portfolio income which is earned interest, dividends, and capital gains. 

What are Passive Activity Loss Rules?

Tax losses occur when the total expenses are greater than the total revenue. When this happens, it reduces the amount of your total taxable income. But with passive income taxes, does it mean the same thing? More importantly, do the same rules apply?

According to the IRS, passive loss is a financial loss incurred through an investment in any trade or business enterprise as long as the investor is not actively involved. In effect, it is similar to a regular tax loss except for the fact that it comes from passive activities such as rental property.

So, what's the rule on passive activity losses? Prior to 1986, passive losses could be deducted from other income earned, allowing individuals to obtain huge tax benefits and offset their income. Because a lot of wealthy individuals started abusing these tax shelters, Congress enacted I.R.C. Section 469, which is known as the passive activity loss rules. These state that passive losses can only be deducted from passive income. It cannot be deducted from earned income like wages and salaries or portfolio income such as dividends.

However, there are exceptions. If your passive income is through real estate, you may be able to deduct passive losses if you're a real estate professional or you actively participate in your rental properties. Some examples of active participation include finding and screening tenants, managing your property yourself, and obtaining estimates for repairs.

Examples of When You Don't Have to Pay Passive Income Tax

Passive income taxes.

Now that you are aware that passive income can be taxed, you want to know how to save money on taxes. Passive income taxes, to be specific.

The first thing you need to know is that passive income is taxed using the same rates as capital gains, ranging from 0% to 20%. This means that it is possible for you not to pay passive income tax if the amount you earn fits within the 0% tax bracket.

Also, similar to non-passive income, if your passive losses are greater than your passive income, then you won't have to pay anything to the IRS.

How is Passive Real Estate Income Taxed?

The passive income tax rate for real estate is different from how other types of passive income are taxed. The income you earn from your rental properties is usually taxed like your regular income. For example, let’s say you earned $500 a month from your rental property. Your total income from other sources is $150,000 at the end of the year. That passive income will then be taxed based on the tax bracket you fall into because of the $150K.

However, unlike earned income, you can deduct depreciation, amortization, maintenance, and repairs from your passive income, which lowers the tax amount considerably.

Passive Income Ideas for Students

Passive income for students.

Financial well-being is not something that only adults should aim for. It's actually a goal that everyone needs to work towards even before they learn how credit cards work. Now, we've already established that one of the best ways to earn money is through passive income. And it's not because passive income tax rates are any lower. This type of income allows you to earn money even while you sleep. Plus, it enables you to focus on more important things. For students, this can mean freedom to study and go to class without spending hours earning non-passive income at your local coffee shop or diner.

To help you get started on your road to financial freedom, below are some passive income ideas for students:

  • Invest in stocks that have dividends
  • Rent out a room
  • Become a peer-to-peer lender
  • Start a blog (affiliate marketing)
  • Rent your car
  • Make YouTube videos
  • Advertising with your car
  • Become an audiobook narrator

You can easily generate much-needed income through one or more of these activities. Some of these activities do not require much capital to get started. Even if you do, you can start by asking for money from your parents (which you can pay back) or look at personal loans. No income during your college days means a longer road towards financial freedom.

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