How is Passive Income Taxed? - The Free Financial Advisor

A lot has been said about passive income.

“If you don’t find a way to make money while you sleep, you will work until you die.” ~ Warren Buffett

“The key to financial freedom and great wealth is a person’s ability or skill to convert earned income into passive income and/or portfolio income.” ~ Robert Kiyosaki

With the above quotes in mind, there is a particular area of passive income that is rarely talked about…taxes.

How is it taxed? Are there particular income streams that are taxed differently than others? How do you optimize so you’re taxed favorably? We’ll cover all of that in the following article.

What is Passive Income?

As defined by the IRS, passive income is either net rental income or income from a business in which the taxpayer does not materially participate.

There are several different kinds.

Forms of Passive Income

Real estate – If you own a property, be it a single-family home, duplex, or apartment complex, the rent you collect from tenants is considered rental income.
Limited partnerships – As a limited partner, your only responsibility is the capital you invested. The general partner manages the day-to-day activities of the business and has unlimited liability in terms of the debt taken on by the business. You receive income as a percentage of the company revenues (percentage based on your percentage of ownership).
Some portfolio income – speak with a tax professional on this subject, as the IRS isn’t quite clear on whether portfolio income is taxed as passive or not.
Peer-to-peer lending – Individuals lending to individuals. If you’re looking for passive income, you lend money to someone, charge them interest, and then collect that interest.
Equipment leasing – buy a piece of equipment and rent it out. Pretty straightforward.

Material Participation

500+ hours of activity per year towards the “business” to which the income is received
Up to 100 hours of participation per year and at least as much as anyone else participating in the activity

Taxes

Passive income is taxed in a couple of different ways. First off, passive income losses can only offset “actual” passive income.

Capital gains

Short-term – Taxed at your ordinary income tax rate. For 2020, the rates are 10%, 12%, 22%, 24%, 32%, 35%, and 37%.
Long-term – Gains from “investments” held for over one year. The tax rates for long-term gains are 0%, 15%, and 20%.

Real Estate

1031 exchange – take capital gains from selling a property and use it to buy another property. Then, you don’t have to pay taxes on those gains.
Tax write-offs – You can write off depreciation, money spent on the property, and amortization (interest on a mortgage).
20% “safe harbor” deduction if your income is below a certain threshold. I’ll link to a resource for more information about this one (see here).

Taxes are anything, but simple. Please speak with a qualified tax professional.