Earning passive income is a great way to diversify your income streams and prevent financial problems in the future. It can also help you grow your wealth more quickly. But how much tax do you have to pay on passive income?
The tax rate on your passive income depends on how you earn the income. At the most, you will pay the rate of your normal tax bracket. Some types, however, have lower tax rates, including when the passive income comes from long-term capital gains.
Take a closer look at passive income to understand better what it is and how you pay taxes on it. If you have several passive income sources, it may be best to consult a tax accountant.
Passive Income Tax
The American tax system is incredibly confusing, so it is no wonder that people tend to have questions about passive income tax. Do you pay your normal tax rate? Do you get a discount? How do you report it?
The answers to these questions depend somewhat on the passive income you earn. The IRS doesn't have a category or form for "passive income." Instead, your passive income will appear in other forms, mixed with your investments, regular income, and rental income. This means that there is no simple answer to what to expect from passive income tax.
What Is Passive Income?
Before getting into passive income taxes, take a moment to refresh your memory on what passive income is. This is the income you make from passive activities. In other words, you earn income without overseeing day-to-day operations or being actively involved.
Most methods of earning passive income will require you to make an upfront investment of either money, time, or both. It is worth noting that the IRS officially outlines two types of passive income. One is rental activities (other than for real estate professionals). The other is any trade or business activities you don't participate in materially. But remember that just because the IRS divides passive income into two categories, that doesn't mean that everything within a given category is taxed the same.
Common Examples of Passive Income
To further illustrate the idea of passive income, the following are some common examples:
- High-yield savings accounts
- Rental income
- Bond index funds
- Dividend index funds
- Dividend stocks
- Real estate investment trusts
- Peer-to-peer lending platforms
- Being a silent partner of a business
What Influences Your Passive Income Tax
What you pay in passive income tax depends on several factors. There is no set tax rate for passive income. The most important factors include:
- The source of the passive income
- The amount of time you spent earning the passive income
- Whether it is income from a rental property
Because of the complexity of passive income taxes, it is smart to at least consult with a tax accountant before filing your taxes. At the very least, consult with one the first year you earn the passive income, so you can better understand how to report it on your taxes in the future.
Paying Taxes on Certain Types of Passive Income
One of the major factors influencing how you will pay tax on your passive income is the source. The following shows how your taxes will work for certain types of passive income.
Investments in Stocks and Bonds
One of the most common methods of passive income is to invest in stocks and bonds. This can be passive, but it is not necessarily passive depending on the level of effort you put into it. It is important to remember that investing in stocks never guarantees profits; you can also lose funds.
In terms of tax, you will pay capital gains tax on stocks and other similar investments. Importantly, this will be either short-term or long-term capital gains tax. The category where it falls is based on the time you held the asset before selling it. To be a long-term capital gain, you must have held the asset for at least a year.
Your short-term capital gains are taxed like the rest of your income. So, they will be taxed based on the tax bracket that you fall into when you add up all of your income. Remember that tax brackets are marginal, so only the amount of money that brings you into the new tax bracket is taxed at a higher rate. By contrast, long-term capital gains are taxed at 0%, 15%, or 20%, depending on your income. Few people will pay more than 15% on long-term capital gains.
Your trading platform will send you Form 1099-B to help complete your taxes on this type of income.
Interest From a Bank Account or Dividends
Dividends and interest from your bank account are also very common types of passive income. These will be taxed at the same marginal tax rate as your other income, with the rate based on your tax bracket.
Your bank or broker will send you Form 1099-INT for investment income and Form 1099-DIV for dividend income. You can use these to complete your taxes easily.
The taxes you pay on passive income from real estate become more complicated. This is because of depreciation. That being said, your rental income is usually taxed at your regular tax rate based on your tax bracket.
You will report your rental property income on Form 1040 (Schedule E).
Depreciation And Rental Income
This means that you can take advantage of amortization and depreciation to lower the amount you have to pay in taxes.
As an example of depreciation, consider you earned a rental income of $20,000, but your property depreciated by $12,000. You would only pay taxes on $8,000 ($20,000 – $12,000 = $8,000). This means that your effective tax rate would be much lower than it would have been without depreciation. For example, a tax rate of 17.43% only applied to the $8,000 would be $1,394.40. That works out to an effective tax rate on the $20,000 of just 6.97%.
Legally, you can include the depreciation of the building itself but not the land. You can do so for 2.75 years.
Operating Expenses And Rental Income
The other complication with paying taxes on rental income is your operating expenses. You will have to deduct these from your earnings to determine your income. Some examples of operating expenses include:
- Property taxes
- Mortgage interest
- Repairs and maintenance
- Property management
- Professional or legal fees
- Tenant screening costs
- Advertising costs
- License and registration fees
- Home office expenses
- Telephone and internet
- Travel expenses related to your property
Reporting Income From Rental Properties
You will need to report your income from rental properties in the year you earn it. This will include:
- Monthly rent
- Rent paid on signing (first and last month)
- Pet rent
- Fees for parking spaces and other amenities
The security deposit and pet deposits are not income unless you keep part of them. Otherwise, they should stay in a trust to return to your tenants. If you keep part of those deposits, you need to report the portion you kept to the IRS.
Capital Gains Tax From Selling Rental Properties
The above applies when you own a property and receive rental income for it. But when you sell the property, that is subject to the capital gains tax. You pay tax on the profit from the sale after you account for the property depreciation and the original price.
As with other capital gains, short-term capital gains are held for less than one year. These are subject to your normal tax rate. If you have owned the property for at least a year, you will pay the lower long-term capital gain tax rate.
Income From Real Estate Investment Trusts (REITs)
This investment product is similar to a mutual fund but for real estate. Your income is usually taxed at your normal marginal tax rate. There may be a surcharge for your investment income, but you will also be able to deduct the combined qualified business tax. This deduction can be up to 20%.
Now That You Understand Passive Income Tax, How Can You Boost Your Passive Income?
Now that you know more about passive income taxes, you may be considering ways to earn passive income. The following are some good options to evaluate:
- Invest in stocks or bonds
- Invest in real estate
- Rent a parking space
- Sell items you don't want anymore
- Get a credit card with a cashback
- Do affiliate marketing
- Write a book
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Passive income tax rates depend on your tax bracket, the income source, and how long you held the relevant stock, bond, or property. If you earn passive income from a rental property, you should strongly consider hiring a tax accountant to help with your taxes and maximize your deductions. If your passive income is from stocks and other investments, you should be able to do your taxes yourself. When in doubt, it is best to consult a tax accountant.
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Shawn Manaher is a former financial advisor, has founded 5 online businesses, and is a coach, speaker, podcast host, and author. He's been featured on Forbes, The Consults Corner on TAE Radio, The Writing Biz, What's Your Story, and more.