Small Business Advice

A complete guide to how passive income is taxed 

Are you looking to make a passive income but aren’t aware of how passive income is taxed? If you answered yes, keep reading to find out all there is to know about income tax in the United States. 

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The majority of Americans work 9 – 5 jobs to earn an ordinary income. However, in more recent years, many entrepreneurs are shifting their focus to the self-employment realm for many reasons. Whether it’s to increase your number of income streams, gain more flexibility in your schedule, or grow your savings account, a passive income can increase your personal finances favorably. And, just like any type of active income, any money earned from a passive income source is considered taxable. In other words, if you are self-employed you will need to pay federal income tax each year like every other American. With that said, not everyone knows about the ins and outs of how passive income is taxed within the United States.

Luckily, we’re going to go over all there is to know about passive income tax so you can confidently grow your income streams without facing consequences from the IRS during tax season. Therefore, keep reading for more information. 

Key takeaways

  • Passive income is defined as revenue earned from rental real estate, limited partnerships, any business activity where an individual does not have active participation 
  • Recurrent income refers to income generated from rental activity on a property once any operation expenses and mortgage interest has been fully paid.
  • If you were to purchase a property and then sell it within a year of the original purchase date, then the interest income you make is considered as earned income.
  • If you purchase a property and keep it for over a year before selling it on the market, then the money you make is considered passive income
  • Passive income can also be made when you loan money to a limited liability partnership or S corporation
  • When you record passive losses on income, passive activity revenue can have deductions that counterbalance as opposite to the total income.

What is passive income?

While there are three central types of income recognized by the Internal Revenue Service (IRS), passive income is defined as earned income from: 

  1. Renting out real estate and equipment 
  2. Limited partnerships (also referred to as self-charged interests) 
  3. Any other businesses where an individual has passive activity in their involvement 

Tip Box: Whether it’s digital downloads, Airbnb rentals, or investing in the stock market, the options for making a passive income are endless. Therefore, if you’re interested in extra income streams, check out more of our articles on side hustles that are worth investing in. 

How passive income is taxed

As mentioned earlier, any money made passively is subject to taxing as active income is in the United States. However, there are some key differences in the tax rules that will determine how you pay taxes, depending on which passive income category you fall under. Let’s take a closer look at how passive income and regular, earned income is taxed. 

Earned income is similar to what a full-time employee makes when they are on salary. Therefore, all earned income you make will be subject to FICA Medicare and social security taxes. The total of these FICA taxes is 15.3%. On the other hand, passive income, especially on real estate, is subject to several tax deductions which can save you more on your tax return as a taxpayer. Don’t worry, we will go over a little later in our article.

Furthermore, now that we understand what passive income is, and how it is taxed, let’s delve deeper into each type of passive income in a little more detail. 

Real estate passive income 

Moreover, while rental properties are considered passive income under federal tax law, there are some key exclusions you should take note of. For starters if you are a real estate professional, then any income you make will be deemed active income. In addition, any rental income you make from leasing a property will not qualify as passive income either. Accordingly, passive income on real estate includes: 

  • Leasing equipment 
  • Rental property 
  • Limited partnerships 
  • Sole proprietors if you are not actively participating in the business 
  • Limited liability corporations if you are not actively participating in the business 

Now, let’s take a closer look at the two different ways how rental property is considered passive income below. 

  1. Recurrent income

Recurrent income refers to income generated from rental activity on a property once any operation expenses and mortgage interest has been fully paid. Additionally, once the depreciation has also been deducted, the final value is considered passive taxable income. Accordingly, the amount of tax you will pay each year will ultimately depend on the tax bracket you are in. However, when generating a passive income from real estate, it is likely that you will be able to save a lot of money as it will be safeguarded by depreciation. 

For example, say you were to purchase a property for $200,000. Throughout the year, this property generates a total of $20,000. Once you have paid your property tax, mortgage, homeowners’ insurance, and other repairs) you are left with a net income of $10,000 before depreciation. 

With that said, as you are making investment income, real estate investors can also depreciate the value of land the home is on. For example, your lot value is $20,000 you would calculate $180,000/ 27.5 years for rental properties to get an income of $6,545. Once this rate is deducted from the $10,000 income you are left with $3,455 in taxable income. Further, depending on your income tax rate, you will only end up paying tax on the depreciated value compared to the net income which will equate to less than the tax bracket you are in. Ultimately, saving you money. 

  1. Capital Income 

Furthermore, if you are looking to make investment income on real estate, you will also pay tax on any capital gains, should you choose to sell your property. Capital gains of course, is the total amount earned from the sale after you have paid capital gains tax. However, there are some differences that we need to go over. Let’s take a closer look below. 

  1. Short-term 

If you were to purchase a property and then sell it within a year of the original purchase date, then the interest income you make is considered as regular. For example, let’s say you purchase a property for $200,000 and then put it back on the market a couple months later at $250,000. Therefore, your net gain of $50,000 would be taxed as a regular income gain, not passive income gain. Thus, depending on your tax bracket you would then only pay tax on the $50,000.

  1. Long-term 

Moreover, if you were to purchase a property and keep it for over a year before selling it on the market, then the money you make is considered passive income. For example, again let’s say you purchase a property for $200,000 and then put it back on the market after four years at $250,000. Therefore, your net gain of $50,000 of passive income would only be taxed for depreciation recapture and long-term capital gain tax depending on your tax bracket. 

Entrepreneurs should also be aware that there are several tax deduction possibilities that you can apply when you pay taxes for the year. These deductions include: 

  • Utility costs 
  • Landscaping costs 
  • Property management expenses 
  • The cost for maintenance and repairs  
  • Property tax
  • Office supplies 
  • License and registration expenses 
  • Phone and internet costs 
  • Insurance premiums on renters’ insurance 
  • And more

Limited liability partnerships 

According to the IRS, “Certain self-charged interest income or deductions may be treated as passive activity gross income or passive activity deductions if the loan proceeds are used in a passive activity.” But what does this mean? Well, also known as a self-charged interest, passive income can also be made when you loan money to a limited liability partnership or S corporation. Any investment income on the money loaned to the partnership in your portfolio income will qualify as passive income. 

In addition, this includes loans you make to partnerships and s corporations and loans the partnerships or S corporations make to you. Further, this also includes loans given on behalf of the partnership or S corporation to another partnership or S corporation if each “owner in the borrowing entity has the same proportional ownership interests in the lending entity” (IRS).  

Further, under the federal tax law regulations of the United States, “the applicable percentage of the taxpayer’s share for the taxable year of each item of the lending entity’s self-charged interest income is treated as passive activity gross income from the activity.”

Passive involvement in business activity 

Lastly, passive involvement in a business can be thought of as a silent investor. For example, say you invested $200,000 into a small business to help an entrepreneur launch their business. You would most likely come to an agreement that the business owner would pay you a percentage of their earnings. However, you would not be able to actively participate in any daily operations or business decisions. Therefore, your only involvement in this small business is the investment you made. Thus, deeming your earnings as passive. On the other hand, if you were to aid the small business owner with managing their company, then your share of earnings would be deemed active, as you gave material participation. 

Accordingly, the IRS has outlined standards surrounding material participation, that include: 

  • Dedicating more than 500 hours of assistance to which you are now profiting off of 
  • Your activity comprised all ‘signficant activity’ within a tax year 
  • You have actively participated up to 100 hours of your time and this time at a minimum is as much as any other person that is also involved with the business 

Some things to consider 

Moreover, another factor entrepreneurs should consider is passive losses. When you record passive losses on income, only passive activity revenue can have deductions counterbalance as opposite to the total income. Accordingly, these deductions are then applied to the following tax year and are applied reasonably in accordance with your earnings and losses next year.  

For example, let’s say you are a passive investor in a business which earns you $5000 a year in profits. On the other hand, you could also be a passive investor with a corporation that lost you $3000 this year. Additionally, you are an active member of the operations of a limited liability corporation to which you owe interest in. However, the limited liability corporation also makes you lose $500 in profits for the year. Therefore, you are able to offset the $3000 loss from the first corporation and only pay passive tax on the $1500 you have left, rather than the $5000. However, while you will not be able to use these losses to offset the passive income, it can be used as a tax credit on any future active income you make next year. 

Passive income tax rates

Furthermore, now that we know what passive income is, and how passive income is taxed, here is a comprehensive chart that indicates the rates for 2021 with the top income tax rate being 37% this year, minus capital gains and dividends. However, please note that these rates are only applicable to single, individual taxpayers and are subject to change if you are filing jointly. 

Tax rate Taxable income bracket Tax owed
10% $0 to $9,950 10% of taxable income
12% $9,951 to $40,525 $995 plus 12% over $9,950
22% $40,526 to $86,375 $4,664 plus 22% over $40,525
24% $86,376 to $164,925 $14,751 plus 24% over $86,375
32% $164,926 to $209,425 $33,603 plus 32% over $164,925
35% $209,426 to $523,600 $47,843 plus 35% over $209,425
37% $523,601 or more $157,804.25 plus 37% over $523,600

Capital gains 2021

Tax-filing status Single
0% $0 to $40,400
15% $40,401 to $445,850
20% $445,851 or more
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