Passive income is the key to reaching financial independence and retiring. With enough passive income, you can ditch your day job — or at least cover the gap between what your current job pays and your dream work pays.
But as with most forms of income, Uncle Sam wants his cut. That could include regular income taxes, self-employment taxes, and capital gains taxes, among others.
What Is Passive Income?
Passive income requires little to no effort to earn and maintain. The most common passive income types include investment properties, dividends from stock market investments, bonds, royalties, or business ventures where employees and managers run the day-to-day operations. But you’ll find a never-ending list of passive income ideas on the internet, ranging from writing e-books to dropshipping.
Surprise surprise, we love buying rental properties as one of the most lucrative passive income types. By purchasing a property and renting it out, investors collect ongoing real estate cash flow. Rental properties also come with huge tax benefits, from landlord tax deductions to property depreciation to ways to avoid capital gains tax on real estate.
But rental income is far from the only type of passive income. From dividends to interest to rents to capital gains, Uncle Sam taxes passive income differently.
How Passive Income Is Taxed
If you want to maximize your returns, you need to understand how passive income is taxed.
The exact taxes on passive income depend on the type of passive income, as taxation laws differ for passive income types. The following represent the most common taxes on passive income.
American taxpayers pay lower tax rates on qualified dividends than ordinary dividends. Specifically, those in the lowest three income tax brackets (0%, 10%, and 12%) pay no taxes on qualified dividend income. Here’s the tax bracket table for qualified dividend income:
|2023 QUALIFIED DIVIDEND TAX RATE||FOR SINGLE TAXPAYERS||FOR MARRIED COUPLES FILING JOINTLY||FOR HEADS OF HOUSEHOLD|
|0%||Up to $44,625||Up to $89,250||Up to $59,750|
|20%||More than $492,300||More than $553,850||More than $523,050|
But how do you know if a dividend counts as a “qualified dividend” or ordinary dividend?
To be taxed as a qualified dividend, the company must be based in the U.S., or listed on a major U.S. stock exchange. You must also have owned the stock for at least 60 days within a specific 121-day period. That period starts 60 days before the ex-dividend date — 60 days before the next dividend is issued. This rule prevents swing traders and day traders from buying stocks within a day or two of the dividend and taking advantage of the lower qualified dividend tax rate.
There are some special rules and exceptions however, even among U.S. stocks, which get taxed as ordinary dividends.
Dividend payments that don’t come from qualified dividends is taxed at your ordinary income tax rate. For tax year 2023, that looks like this:
|2023 ORDINARY DIVIDEND TAX RATE||FOR SINGLE TAXPAYERS||FOR MARRIED COUPLES FILING JOINTLY||FOR HEADS OF HOUSEHOLD|
|10%||Up to $11,000||Up to $22,000||Up to $15,700|
|12%||$11,000 to $44,725||$22,000 to $89,450||$15,700 to $59,850|
|22%||$44,725 to $95,375||$89,450 to $190,750||$59,850 to $95,350|
|24%||$95,375 to $182,100||$190,750 to $364,200||$95,350 to $182,100|
|32%||$182,100-$231,250||$364,200 to $462,500||$182,100 to $231,250|
|35%||$231,250 to $578,125||$462,500 to $693,750||$231,250 to $578,100|
|37%||Over $578,125||Over $693,750||Over $578,100|
Unfortunately, dividends from real estate investment trusts (REITs) don’t count as qualified dividends. That includes dividends from real estate crowdfunding platforms such as Fundrise and Streitwise, and certain pass-through entities including master limited partnerships.
Real estate investments? Awesome. Being a landlord? Less fun.
Learn how to earn 15-30% on passive real estate investments in one free class.
Interest from Bonds & Loans
In most cases, you pay the same tax rate on interest income as your regular income tax rate. That includes bond interest, high-yield savings account interest, and interest on loans such as private notes or your Groundfloor investments.
However, municipal bonds are tax-exempt, and you pay no federal income taxes on the interest. If you bought them in your home state or city, municipal bonds might also be exempt from state and local income taxes. Accountants refer to these as triple tax exempt.
You can also avoid paying federal income tax on Series I or Series EE bonds if you use the money for qualified education expenses such as tuition and fees. Read up on these IRS exemptions here.
Income from rental properties is generally taxed at your normal income tax rate.
However, landlords can take over 20 types of rental property tax deductions. You can also take rental property depreciation, and potentially show a paper loss even though you earned real income from your rental property.
Landlords can use these passive losses to offset either other passive income types or up to $25,000 in active income such as W2 paychecks.
You may also be able to take the qualified business income deduction, also known as a Section 199A or pass-through income deduction. But do your homework on whether you can take the QBI deduction as a landlord, speaking with either a tax code specialist or at the very least researching the IRS rules on it.
Report rental activity income on Schedule E of your tax return. That means you can take deductions on real estate activities while also taking the standard deduction. Make sure you keep evidence of all rental property income and expenses you deduct in case you face a tax audit. That goes doubly when you report rental losses.
Uncle Sam also taxes distribution income from real estate syndications at your regular income tax rate. However, often limited partners (passive investors) in real estate syndications pay no taxes until the property sells, since syndicators typically accelerate the depreciation using a cost segregation study. Read up on how to invest in passive real estate syndications as a member of our real estate investment club.
Capital gains tax is a tax applied to the profit when you sell an investment. Capital gains tax is applied to the difference between the initial investment amount (your cost basis) and the total proceeds from the sale of the asset.
Capital gains taxes are primarily determined by the length of time you own an asset, or how long it’s held. Short-term capital gains taxes apply to investments held for one year or less, while long-term capital gains taxes apply to investments held for more than a year. Short-term capital gains are taxed at your regular rate while long-term capital gains have a typical rate of 15% (20% for high earners). But like dividend income, Americans in the lowest three tax brackets pay no long-term capital gains tax on profits.
Anyone who owns a business or works as an independent contractor must pay self-employment taxes. It applies regardless of your “material participation” in business activities — whether you work it like a full-time job or completely passively.
Self-employment tax is a form of tax applied to certain types of income derived from self-employment, such as freelancing or running an LLC, and is generally made up of the Social Security and Medicare taxes.
As a business owner, you pay both the employer and employee sides of FICA taxes. These double FICA taxes typically apply at a flat rate of 15.3%.
When it comes to passive income, self-employment tax applies in the same way that it would to any other form of self-employment income. This means that an individual who earns passive income (from dropshipping, selling printables, or selling online courses, for example) must pay self-employment tax on the income earned. This applies even if the individual is not actively participating in the activities associated with earning the income.
Self-employed workers like real estate professionals and anyone earning 1099 income must also pay self-employment taxes.
The Internal Revenue Service taxes royalty income from art, written works, or other intellectual property at your ordinary tax rate.
As for tax forms, you typically list it on Schedule E on your tax return.
NIIT-Picking: Net Investment Income Tax
If you earn too much money, Uncle Sam taxes you extra. Enter: the net investment income tax (NIIT).
Single taxpayers with a modified adjusted gross income (MAGI) over $200,000 must pay an extra 3.8% tax on investment income. The threshold only goes up slightly to $250,000 if you’re married filing a joint return.
The NIIT applies to the following passive income types:
- Dividends (qualified and nonqualified)
- Capital gains (short- and long-term)
- Taxable interest
- Rental and royalty income
- Passive activity income (from investments you don’t actively participate in)
- Business income from trading stocks, ETFs, mutual funds, or commodities
It does not apply to:
- Tax-exempt interest from municipal bonds or funds
- Tax-exempt income from the sale of your primary home (section 121 exclusion)
- Defined benefit pension plan or retirement plan annuity payments
- Payouts from a deferred compensation plan from a state, local government, or tax-exempt organization
- Life insurance proceeds
- Income from a business you actively participate in
One more reason to take advantage of real estate tax advantages and depreciation!
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Passive Income That’s Not Taxed
There are very specific types of income that you earn passively that won’t face taxation in the same way as other income streams. A couple of examples include:
- Some municipal bonds: Municipal bonds are an agreement between a borrower (such as a city or a state) and a lender where the borrower agrees to pay a certain sum of money to the lender over a predetermined length of time. The interest payments from such bonds are not typically subject to federal taxes.
- Life insurance proceeds: Life insurance proceeds are generally not subject to income tax when they are paid out to the beneficiaries of the policy.
- Alimony and child support: Payments made in the form of alimony or child support are considered non-taxable income by the IRS because they’re not considered income for the recipient.
- Inheritance money: Inheritance money is typically not subject to taxation since it’s not considered income. Substantial estates may have to pay estate taxes, though.
Understanding Tax Deductions for Passive Income
Passive income is subject to a variety of taxes just like ordinary income is. You may face income taxes, self-employment taxes, and capital gains taxes. Understanding the deductions associated with these taxes can help lower your tax burden and maximize your after-tax return on passive income investments.
- Business expenses deduction: Depending on the nature of the passive income, there can be many business expenses associated with it. Common business expenses for passive investments include advertising, accounting fees, and travel expenses related to the investment.
- Home office deductions: If you exclusively use a portion of your home as your primary place of business, you may be able to take the home office deduction. Deductible expenses include rent or mortgage payments, utilities, and insurance premiums. Be careful with this one though, the IRS has cracked down on it in recent years.
- Capital losses: Capital losses can be used to offset capital gains to an extent, reducing your overall tax liability. You can “artificially” create losses through tax loss harvesting (more on that momentarily).
By understanding the deductions available to reduce your passive income tax liability, you can maximize your after-tax return. For more detailed information, consult with a tax professional.
Minimizing Taxes on Passive Income
Understanding how to use our tax system to your advantage is no easy task, but there are ways to reduce the amount of taxes you have to pay. Here are some key strategies to consider:
- Utilize tax deductions: As the section above should have proven to you, there are a considerable number of deductions available to you, such as those for expenses related to maintaining or managing your passive income streams.
- Utilize tax loss harvesting: Tax loss harvesting is a strategy that involves selling investments at a loss in order to offset any gains in the current tax year. This can help to reduce the amount of taxes you owe on any passive income you receive.
- Open a retirement account: Retirement accounts such as a Traditional IRA or Roth IRA can help to reduce taxable income and offer tax-advantaged growth opportunities. Contributions to these accounts are tax-deductible, and the income generated within them is not taxable until withdrawn.
- Utilize tax shelters: Tax shelters such as annuities and real estate syndication can offer tax savings. Be sure to consult with a tax professional to ensure that any tax shelters you consider utilizing meet IRS requirements.
Final Thoughts on Taxes on Passive Income
How passive income is taxed gets complex and confusing quickly. However, a basic understanding of the taxes on passive income and how to reduce them helps you lower your effective tax rate.
Knowing which portfolio income streams are taxable, understanding which tax rate applies, and taking advantage of available deductions and credits can help minimize the amount of taxes owed on passive income. That especially goes for real estate investors, who may earn money on rents, loan proceeds, capital gain income on properties, and falls under either active participation or passive activity rules.
And as a bland but no less true final piece of advice, consult a tax professional to ensure all taxes are paid correctly and accurately.♦
What are your favorite ways to reduce taxes on passive income? What questions do you still have about how passive income is taxed, especially income from real property?