Passive income is defined as money you earn with minimal or no effort. For example, earnings from a rental property, limited partnership, or other business are considered passive income. The IRS divides income into active, passive, and portfolio categories. Passive income is taxable and must be reported to the IRS, but there are some key things you’ll want to know about passive income taxes.
Qualifying Types of Passive Income
Types of passive income include self-charged interest, rental income, and profits from businesses where the person receiving the payment has no significant involvement. To qualify for passive income, one must adhere to specific IRS regulations.
The interest income from a loan made by the entity’s owner to a partnership or an S corporation functioning as a entity could get classified as passive income. A pass-through entity is also called a flow-through entity is a business that passes all of its income directly to the owners or shareholders. This means that only the individuals are taxed, not the business itself.
Rental properties often qualify as passive income. However, if you’re a real estate professional, your rental income would be seen as active.
Income derived from leasing land is also not deemed to be passive. However, the landowner may benefit from the passive income loss rules if the property nets a loss. If the losses exceed the income from qualified passive activities, the rest of the loss can be carried forward and claimed the next tax year.
No Material Participation
“No Material Participation” comes from a business you have no active involvement with. Still, if you helped manage the company or invested your time, it could be seen as active income. The IRS has a series of seven tests one must meet to determine if they meet the “no material participation” requirements.
There are many ways people make passive income. Some examples include:
- Equipment leasing
- Real estate rentals
- Sole proprietorship where the individual does not materially participate
- Limited partnerships
- Partnerships, S-Corporations, and LLCs where the individual meets the no material participation rules
Passive Income Tax Rates
Passive income taxes are usually subject to the same rate as wages from a job, though there are times when deductions lower the liability. The tax rate depends on the tax bracket and file status, with rates ranging from 10% to 37%.
Rules vary depending on the type of passive income taxed. Interest income is considered ordinary income, so the tax rate on interest is your standard income tax rate.
Periodic payments to shareholders by corporations and mutual fund companies are known as cash dividends. Ordinary dividends and qualified dividends are the two types separated for income tax purposes. Dividends get taxed at their own rate.
Capital gains are the profit made from selling an asset that increased in value while you owned it. Depending on your income bracket, long-term capital gains (assets held for longer than a year) get taxed at 0%, 15%, and 20%. Individuals filing as single and making less than $39,375 would owe 0% of any long-term capital gains.
Passive Income Tax Benefits
Despite passive income being subject to ordinary income tax rates, it’s still tax-advantaged. Here are some benefits and tax breaks associated with passive income.
Social Security and Medicare Taxes
Passive income isn’t liable for Social Security and Medicare taxes. The combined 15.3% Social Security and Medicare taxes are automatically eliminated, leaving an extra 14 cents of every dollar in your pocket.
Real Estate Deductions
With lower tax rates, buying real estate and high-yield rental properties is an attractive option for investors. The qualified business income deduction for purchasing and holding real estate is a 20% deduction from taxable income. In 2022, investors could deduct 20% of their real estate investment properties, increasing the return on investment.
To claim the 20% deduction, one must make a “pass-through deduction” (New 199A). Although that pass-through income is subject to 20%, LLCs, sole proprietorships, and S-corporations can shift taxes.
Mortgage interest payments on loans made to buy or improve rental properties can be deducted. The interest on credit cards used to fund rental property activity are also deductible.
Some real estate taxes can be avoided by using Section 121 and 1031 exchanges. Investors can use the 1031 Exchange to their advantage when selling a profitable home and save money on capital gains taxes.
The owner qualifies for Section 21 and only pays a portion of taxes on the profit when they sell the house if they have lived in it for two out of the last five years. Then, to avoid paying taxes on the home sale, use the 1031 Exchange to purchase a rental property with some of the profit made.
There’s a 100% depreciation bonus available on certain business assets. If something depreciates in less than 20 years, the expense can be entirely written off in the first year. Qualifying depreciable assets in a small business may include machinery, equipment, computers, appliances, and furniture.
For instance, say your business spends $10,000 on a business computer. Under normal tax circumstances, you would report $1,000 in depreciation every year for the next decade. With 100% depreciation, you can deduct the whole value ($10,000) the same year you bought the item and began using it.
A tax incentive known as bonus depreciation enables business owners to report a larger portion of depreciation in the year the asset was bought and put into use. You are permitted to deduct up to 100% of an asset’s cost from your business taxes in the year of purchase. However, there are limitations, and not all assets are eligible.
Consult an Expert
Tax laws are constantly evolving, but you can familiarize yourself with the latest passive income taxes by checking out IRS.gov. Contact a tax advisor or professional to learn more about the benefits of passive income. With passive income, you may be able to increase ROI, save money, and write off eligible expenses on your future tax returns.
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