Passive income, such as rental income from real estate properties or dividend income from investments, can be a great way to earn money without actively working. However, many investors may be surprised to learn that passive income is taxed just like active income.
In this article, we’ll share 7 surprising facts about how passive income is taxed that every investor should know. From deduction and credits for rental real estate properties to special tax rules for certain investments, understanding these facts can help investors make informed decisions about their passive income and potentially lower their overall tax liability. So, if you’re an investor looking to maximize your passive income, make sure to read on and discover these little-known facts about passive income tax.
Fact #1: Passive income is taxed at the same rate as regular income
One of the first things to understand about passive income is that it is taxed at the same rate as active income, it’s all taxable income. This means that if you’re in the 22% tax bracket for regular income, your passive income will also be taxed at 22%. However, it’s important to note that the thresholds for each tax bracket may be different for passive income, so be sure to check the IRS guidelines for the most up-to-date information.
It’s also important to understand that passive income is not the same as “tax-free” income. Some investors may assume that because they are not actively working for the income, they won’t have to pay taxes on it. However, this is not the case. All income, including passive income, is subject to federal income tax, again it’s all taxable income.
Additionally, it’s important to note that the tax rate on passive income may be different depending on the state you live in. Some states have a higher tax rate on passive income than others, or even no state federal tax at all. Furthermore, passive income is also subject to self employment tax if it comes from a partnership or S corporation, which can add an additional 15.3%(12.4% for Social Security and 2.9% for Medicare) of your overall tax liability.
It’s essential for investors to understand the tax implications of their passive income in order to plan and budget accordingly. Consulting with a tax professional or reviewing the IRS guidelines can help investors ensure they are taking advantage of all available deductions and credits and paying the correct amount of taxes on their passive income.
Fact #2: Certain deductions and credits may apply to passive rental income from real estate properties
One of the biggest surprises for many investors is that passive income from rental real estate properties may be eligible for certain deductions and credits. For example, you may be able to claim deductions for mortgage interest, rental property taxes, and certain repairs and maintenance. These deductions can help to lower your taxable rental income and lower your overall tax liability.
Additionally, you may be able to claim the Lifetime Learning Credit or the American Opportunity Tax Credit if you rent out a property that you also use as a residence. These credits can provide a dollar-for-dollar reduction of your tax liability, and are available for certain expenses related to the rental of a qualified residence.
Furthermore, if you make energy-efficient improvements to your rental real estate property, you may be eligible for the Residential Energy Efficient Property Credit. This credit is for homeowners who make energy-efficient improvements to their rental properties, such as installing solar panels, wind turbines, or geothermal heat pumps.
Another important thing to consider is the depreciation of the property. Depreciation is a method of recovering the cost of a property over a period of time, and it’s used to calculate your taxable income for the year. Rental properties can be depreciated over 27.5 years, which can provide a significant tax benefit for investors over time.
In addition, if you have multiple rental properties, you may be able to offset any loss from one property with the gain from another property. This is known as passive loss limitation rules and can help to lower your overall tax liability.
However, it’s important to note that these deductions and credits have specific rules and limitations, and it’s important to consult with a tax professional to ensure you’re taking advantage of all the available options and avoid any potential errors. Furthermore, as a general rule, if your rental activity is considered a business by the IRS, it’s subject to self-employment taxes, so it’s important to understand the difference between a passive income and an active income.
This is why it’s crucial for investors to understand the tax implications of their rental properties in order to plan and budget accordingly. Consulting with a tax professional or reviewing the IRS guidelines can help investors ensure they are taking advantage of all available deductions and credits, and paying the correct amount of taxes on their passive income from rental properties. This can significantly lower their overall tax liability and maximize their passive income potential from their real estate business.
Fact #3: Passive income from a partnership or S corporation may be subject to self-employment taxes
Another surprise for investors is that passive income from a partnership or S corporation may be subject to self-employment taxes. This means that along with paying your regular income taxes, you’ll also need to pay an additional 15.3% on top of your regular income taxes for this type of passive income. The self-employment tax is comprised of two parts, which are Social Security and Medicare taxes and is intended for people that are self-employed or have a partnership or S corporation.
Self-employment taxes, are typically applied to income earned by self-employed individuals and certain types of pass-through entities such as partnerships and S corporations. However, it’s important to note that there are exceptions to this rule. For example, limited partners in a partnership may not be subject to self-employment taxes on their share of the partnership’s income. Similarly, passive investors in an S corporation may also be excluded from self-employment taxes on their share of the S corporation’s income.
It’s also worth noting to say that C corporation income, which are separate taxable entities from their owners, are not subject to self-employment taxes but are subject to corporate income tax.
It’s essential for investors to understand the tax implications of their passive income from a partnership or S corporation in order to plan and budget accordingly. Consulting with a tax professional or reviewing the IRS guidelines can help investors ensure they are paying the correct amount of taxes on their capital gain and passive income, and taking advantage of any available exceptions or exclusions. However, I have to clarify that passive income earned by a C Corporation is subject to corporate income tax, not self-employment taxes. Shareholders are then subject to personal income tax on any dividend income they receive from the corporation.
Additionally, if you’re planning to form a partnership or S corporation, it’s important to consider the self-employment tax implications beforehand.
Overall, understanding the self-employment tax implications of passive income from a partnership or S corporation is crucial for investors to make informed decisions about their passive income and potentially lower their overall tax liability. This is why it’s important for investors to consult with a tax professional or review the IRS guidelines for the most up-to-date information about the tax treatment of their passive income from a partnership or S corporation.
Fact #4: Passive income from certain activities may be eligible for lower tax rates
Passive income taxed from certain activities, such as from a qualified business or from a passive activity under the IRS’s rules, may be eligible for lower tax rates on the earned income. This can be a huge benefit for investors, as it can significantly lower your overall tax liability. However, it’s important to note that these lower tax rates may come with certain restrictions, so be sure to consult with a tax professional to understand the specific rules and regulations that apply to your situation.
A qualified business is defined by the IRS as a business in which the investor does not actively participate. This means that the investor cannot make management decisions, cannot be involved in the day-to-day operations of the business, and cannot provide services to the business. If the investor meets these criteria, then the passive income tax from the business may be eligible for a lower tax rate.
Another way to qualify for lower rates on passive income tax is through passive activities. A passive activity is defined by the IRS as an activity that involves little or no material participation from the investor. Examples of passive activities include real estate rental properties, limited partnerships, and certain types of investment income. The IRS has specific rules for determining what constitutes a passive activity, so it’s important to consult with a tax professional or review the IRS guidelines for the most up-to-date information.
It’s important to note that passive income from a rental property may be eligible for lower tax rates if the investor meets certain criteria. For example, if the rental property is considered a “qualified business” as defined by the IRS, the earned income from the property may be eligible for a lower real estate tax rate.
It’s essential for investors to understand the tax implications of their passive income stream from certain activities in order to plan and budget accordingly.
Additionally, it’s important to note that the Tax Cuts and Jobs Act of 2017 introduced some changes to the tax treatment of passive income, such as the Qualified Business Income Deduction (QBI) which is available for certain types of passive income from qualified business activities. It’s important to stay informed about any new laws or regulations that may affect the tax treatment of your passive income, and to consult with a tax professional or review the IRS guidelines for the most up-to-date information, I can’t say this enough.
In summary, understanding the tax implications of passive income from certain activities and how it may be eligible for lower tax rates can be a valuable tool for investors looking to maximize their passive income gain and lower their overall tax liability. However, it’s important to keep in mind that these lower tax rates may come with certain restrictions and it’s really important to consult with a tax professional to ensure compliance with the rules and regulations. Additionally, staying informed about any new laws or regulations that may affect the tax treatment of your passive income stream can help investors make informed decisions and take advantage of any new opportunities to lower their tax liability and maximize their gain.
Fact #5: Foreign passive income may be subject to foreign tax credits
If you have passive income from foreign sources, you may be subject to foreign tax credits. This means that you’ll need to pay taxes to the foreign country where the income is generated, but you may be able to claim a credit on your US taxes for the taxes paid to the foreign country. This can help to prevent double taxation and lower your overall tax liability.
However, it’s important to note that there are specific rules and regulations for claiming foreign tax credits. For example, the foreign tax credit is generally limited to the amount of US tax that would be paid on the foreign income. Additionally, certain types of foreign earned income, such as passive income from certain foreign corporations, may not be eligible for the foreign tax credit.
It’s important for investors to understand the tax implications of their foreign passive income in order to plan and budget accordingly. Consulting with a tax professional or reviewing the IRS guidelines can help investors ensure they are taking advantage of all available options to lower their overall tax liability, including foreign tax credits. Additionally, it’s important to stay informed about any changes in the tax laws that may affect the foreign tax credit score and how it applies to foreign passive income.
Fact #6: Passive income from certain investments may be subject to special tax rules
Certain types of passive investment income, such as from capital gains or short-term investments, may be subject to special tax rules. For example, capital gains on investments held for more than a taxable year may be taxed at a lower rate than ordinary income. Additionally, short-term investments may be subject to higher tax rates. It’s important to understand these special tax rules, as they can have a significant impact on your overall tax liability.
When it comes to capital gains income, long-term capital gains are taxed at a lower rate than short-term capital gains. Long-term capital gains are defined as gains on investments held for more than a tax year. The tax rate on long-term capital gain income is based on the investor’s tax bracket and can be as low as 0% for some taxpayers. Short-term capital gain, on the other hand, is taxed at the same rate as ordinary income and can be as high as 37%.
Another important thing to consider is the tax treatment of dividends. Dividends from certain types of stocks may be eligible for special tax treatment, such as qualified dividends, which are taxed at a lower rate than ordinary income. Additionally, it’s important to note that some states have different tax rates for dividends, so it’s important to check the tax laws in your state for investment income.
It’s essential for investors to understand the special tax rules that apply to their passive income from certain investments in order to plan and budget accordingly. Consulting with a tax professional or reviewing the IRS guidelines can help investors ensure they are taking advantage of all available options to lower their overall tax liability and maximize their passive income potential.
Fact #7: The tax treatment of passive income may change under new tax legislation
Finally, it’s important to keep in mind that the tax treatment of passive income may change under new tax legislation. This means that laws and regulations affecting passive income can change, and investors need to stay informed about any new laws or regulations that may affect their passive income. For example, the Tax Cuts and Jobs Act of 2017 introduced some changes to the tax treatment of passive income, such as the Qualified Business Income Deduction (QBI) which is available for certain types of passive income from qualified business activities.
It’s important for investors to stay informed about any new laws or regulations that may affect their passive income, as these changes can have a significant impact on their overall tax liability.
In addition, investors should be aware of the fact that the tax laws are subject to change as per the government policies and this could lead to a different tax treatment of their passive income. Therefore, it’s important to review the tax laws and regulations regularly, and consult with a tax professional if necessary to ensure compliance and take advantage of any new opportunities or deductions that may become available.
Final Thoughts On How Passive Income Is Taxed
In conclusion, passive income is taxed just like regular income, but there are some nuances to how it is treated for tax purposes. From deductions and credits for real estate rental properties to special tax rules for certain investments, understanding these facts can help investors make informed decisions about their passive income and potentially lower their overall tax liability. So, if you’re an investor looking to maximize your passive income, make sure to consult with a tax professional or review the IRS guidelines for the most up-to-date information. Additionally, stay informed about any new laws or regulations that may affect your passive income.
We recently published an article about passive income on Etsy, it’s a good read if you still don’t have any passive income stream.
