Is Passive Income Taxable?

How Does the IRS Define Active vs Passive Income for Tax Purposes?

Active income is generated from a job or business that an individual actively participates in. Examples of active income include wages, bonuses, salaries, commission, and net earnings from self-employment.

Passive income is earned with little to no effort from the person receiving that income. In other words, someone with investments, dividends, or interest did not perform material work to generate income.

The IRS provides “material participation tests” in Publication 925 that help determine whether income is active or passive and how to tax it.

Which IRS Forms and Schedules Are Used to Report Passive Income?

Schedule E for Form 1040 reports passive income or loss from partnerships, rental real estate, S corporations, royalties, trusts, residual interests in Real Estate Mortgage Investment Conduit (REMICS), and estates.

Form 8582 calculates and reports passive activity credits and losses. It is frequently used in conjunction with Schedule E.

Schedule C for Form 1040 reports profits or losses from businesses owned by the taxpayer. The income is considered active if you materially participate in your business. However, if you do not materially participate, it may be considered passive income.

Schedule F for Form 1040 reports profits or losses in farming ventures. Like Schedule C, the outcome of material participation tests determines whether the income or loss is active or passive.

What Is the Tax Rate on Passive Income?

Passive income tax rates depend on the type and amount of income. For example, passive income from short-term capital gains of less than a year is taxed at the taxpayer’s ordinary rate.

Long-term capital gains of more than a year are taxed at preferential rates of up to 20%.

Although passive income isn’t usually tax free, you will pay a 0% tax rate if your income is less than:

• $44,625 for single and married filing separately
• $89,250 for married filing jointly
• $59,750 for head of household

A 15% rate is applied to taxable incomes that are between:

• $44,625 – $492,300 for single filers
• $44,625 – $276,900 for married filing separately
• $89,250 – $553,850 for married filing jointly
• $59,750 – $523,050 for head of household

When taxable income exceeds the threshold ranges for 15%, the IRS applies a 20% capital gains rate.

Other passive income such as dividends, royalties, interest, and rental income are usually taxed at the taxpayer’s ordinary tax rate.

Also keep in mind that high-income earners making over $400,000 annually pay an additional 3.8% net investment income tax (NIIT) on passive and net investment earnings.

Is Passive Income Subject to Self-Employment Tax?

In most cases, passive income is not subject to self-employment tax. However, there are exceptions to this tax rule. For example, if a real estate professional meets certain criteria and materially participates in real estate activities, any rental income they earn may be subject to self-employment tax.

Even when it appears to be a passive activity, active participation in a business can result in self-employment tax on the income generated.

For instance, a small rental property business owner may be taxed on rental income despite having a property manager.

Even though the property manager handles routine daily tasks, the owner participates in tenant screenings, property renovations, and other non-passive activities.

Are There Tax Benefits to Earning Passive Income?

Yes, there are several tax benefits to earning passive income from long-term capital gains and tax-deferred retirement accounts, such as IRAs and 401(k)s.

These accounts offer preferential tax rates for long-term investments and reduce current tax liability when withdrawn in retirement.

Roth IRAs allow account holders to contribute after-tax dollars, but their earnings and withdrawals in retirement are generally tax-free.

Rental property owners may deduct a portion of the cost of their property over time, which can help reduce taxable income.

Interest income generated from municipal bonds is generally exempt from federal taxes.

What Is the Passive Activity Loss (PAL) Rule?

The PAL rule limits losses from passive activities to offset income from other activities, allowing unused losses to be carried forward for future use.

Some exceptions exist, like the $25,000 rental real estate loss allowance for certain taxpayers.

The PAL rule was implemented to prevent taxpayers from offsetting their taxable income with losses from passive activities.

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