More and more people are now earning their money through passive income from various investments. These income streams may veer away from traditional jobs, however, they still have their own way of getting taxed. Many individuals don’t realize this and can get in trouble with local and federal tax authorities.
As you read through this article, you will discover that passive and active incomes have relatively the same tax rates, however, understanding the basics and the difference of passive income tax rates is critical, so you can be prepared this coming tax season.
Taxing Income In The United States
Before you dwell on passive income tax rates, you should familiarize yourself with the basics of the income tax in the United States. The Internal Revenue Service or IRS oversees the tax code of the country and tailor tax treatments to income based on different factors.
Two key tax treatments rely on whether the income is “ordinary income” or “passive income”. Examples of ordinary income are salaries and wages earned by an employee or capital gains from short-term strategies from the sales of an asset. Passive income, on the other hand, may refer to rental income, interest income, and qualified dividend income.
The taxing income rule in the U.S. follows a progressive tax table. They use seven marginal tax brackets. This means that the tax amount will depend on the value of the income of a person. It also does not rely on a uniform percentage of the earnings. The higher your income is, the higher your tax will be. These tax tiers range from 10 percent at the bottom level up to 37 percent at the top level.
To compare, passive income does not fall under the seven tax brackets stated above. Instead, they have their own favorable rates. This can go from 0 percent on certain levels of income up to a maximum of 20 percent.
What Is Passive Income Activity?
The IRS defines passive activity as “any rental activity or any business in which the taxpayer does not materially participate.” Material participation refers to the involvement of a person in the activities of the company or business in a continuous, substantial, and regular basis.
What Are The Material Participation Standards?
The material participation standards are as follows:
- You contributed more than 500 hours of your own time to the respective activity.
- Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
- You contributed more than 100 hours over the course of the current tax year. Not only that, but you need to have also participated at least as much as any other participant did.
- The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year.
- You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
- The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.
- Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.
Take note that if you fail to achieve at least one of the criteria above, you will automatically be a recipient of non-material income.
Passive income is referred to as the income you earn while you’re sleeping. In other words, you don’t receive money depending on the time and effort you spend on the office.
Passive Income Categories
According to the IRS, there are two categories of a passive activity. The first type is business, where the individual or a group of people does not materially participate in a continuous, substantial, and regular basis. The second one, on the other hand, is rental, which covers real estate and equipment. To be specific, the following are considered passive activities by the government:
- Rental real estate (several exceptions apply)
- Equipment leasing
- Limited partnerships
- Sole proprietorship or farms where individuals do not materially participate
- S-Corporations, partnerships, and LLCs where individuals do not materially participate
How Is Passive Income Taxed?
Short-Term Passive Income Tax Rates
Short-term gains refer to assets that are held for only less than a year and are taxed as ordinary income. This means that short-term capital gains have the same income level tax rates as your income tax. The seven brackets of progressive tables apply here. The levels are as follows: 10%, 12%, 22%, 24%, 32%, 35%, and 37%.
Let’s say that you continuously bought and sold stock in the past year or less. As a result, you earned $9,000 over-all profit. If you’re filing as a single taxpayer, you will most likely be placed in the lowest tax bracket by the government. As seen above, this has a rate of 10 percent. Hence, you owe $900 in short-term capital gains tax.
On the contrary, higher earners will be be placed in the most upper tax bracket. For example, you were able to earn at least $510,301 in value. This has a rate of 37 percent or $188,811 of tax owed as a single-filer.
Long-Term Passive Income Tax Rates
Compared to the short-term capital gains tax, the long-term passive income tax rates have fewer rates. They are only taxed at three levels based on your income bracket: 0%, 15%, and 20%.
The government will not require you to pay anything if you are a single taxpayer and is earning less than $39,375 for the year. Those inclined on selling long-term assets or investments, and making between $39,376 and $434,550 in yearly income will have to set aside a 15 percent tax rate. Lastly, those who earn higher than $434,550 should pay the maximum 20 percent tax rate.
Take note that married individuals that are filing jointly have their own rules. If they are earning a yearly income below $78,750, they will not be taxed on investment capital gains.
From here, you can notice that holding investments for a short period will only result in higher tax rates.
Real Estate Income Tax
Although real estate income tax is considered a passive income activity, they have their own set of rules. The qualified business income in buy and hold real estate now amounts to a 20 percent deduction on taxable income. According to experts, this rule only results in a higher return on investment (ROI). So, how do real estate investors benefit from these new tax cut acts?
Mortgage Interest Deduction
To improve a subject property, investors are now allowed to deduct their covered interest on mortgage loans or payments. They even have the option to deduct the interest on credits. This is something that property owners use to maintain the property.
One of the most significant tax benefits felt by real estate passive income investors is the depreciation losses. They now have the option to deduct a part of their basis (cost of acquiring the property less the value of land) per year in 27.5 years. This benefit will stop only if you do one of these things: you deduct the entirety of the basis, you take the property out of service or you sell the property.
According to the IRS, you can deduct the repairs from the overall value if they are proven to be necessary and ordinary. It also has to fall under the category of within a “reasonable amount.” You have to take note, however, that these repairs can only be deducted on the year of its application. Common maintenance allowed by the IRS includes fixing floors, repairing broken windows, repainting, plastering, and fixing leaks.
Traveling From Rental Activity
One of the things that passive income investors are not familiar with is the tax deduction made related to the physical upkeep of the property. The IRS revealed that you could deduct the entire amount you spent traveling for the sake of maintaining and running the property. Just make sure that the money you subtract is solely connected to your visits for rental activities.
Home Office Deduction
Unlike most professionals, passive income investors rely on the setup work from home. With the new taxing rule, they are now allowed to deduct the expenses they make in their home office. This will depend, however, if they meet the minimal criteria. According to IRS, “The home office deduction is available only if you are running a bona fide business. If the IRS decides that you are indulging a hobby rather than trying to earn a profit, it won’t let you take the home office deduction.”
Follow these steps to ready yourself in confirming your home office.
Take a photograph of your home office and include a copy of your tax folder. Make sure to include a diagram that will determine and show the relative size of the office compared to the living space.
Promote your home office address on your online platform. You should also include the said address to all of your business cards and stationery to establish it. This will ensure that all physical mails that you need for business will be routed to the said address.
Aside from the billing address, you should also make sure that you are reachable by your customers. Instead of using your personal hotline or phone, you should install a separate phone line that will only be exclusive for business purposes. This is critical when the IRS is auditing the office.
Keep a record and log any of the customers or clients who visit your home office. This technique will fully support the fact that your home office caters to a legal environment for your services.
Perform a time and motion study. For a month or two, record the exact time of your movement. Take note when you are working at home or when you’re just chilling, as well. This will help you determine how much time you’re spending on your passive income endeavors.
How Much Savings Can You Get From Passive Income Tax Rates?
Although there are different kinds of passive income tax rates, let’s assume that the long-term gain is the go-to level. As mentioned above, ordinary income tax rates progressively increase, starting from 10 percent up to 37 percent. The more money you earn, the more tax you have to pay. Although the setup in the passive income is almost the same, it has a lower tax range from 0 percent to 20 percent. Being in whatever bracket will bring you an average of 10 to 15 percent savings.
Now that we have covered the various topics under passive income tax rates, it’s essential to study your position in the industry and see how your tax rate setup will be. You also have the option to consult expert advisors. Ask the best tax advisors or investment consultants on how you can manage your tax rates.
You may even ask them with strategies on how you can further lower your contributions. You can attain this through direct and immediate tax breaks. Qualifying here will give investors several benefits – increased ROI, higher savings, and lower qualified expenses on the next tax return.
I am a financial expert with a deep understanding of passive income and its tax implications. My expertise in finance comes from years of practical experience and continuous learning in the field. I've helped individuals navigate the complex world of taxation, especially in relation to passive income.
Now, let's delve into the concepts mentioned in the article about passive income tax rates:
Taxing Income in the United States:
- The IRS oversees the tax code in the U.S., differentiating income into "ordinary income" (e.g., salaries, wages, and short-term capital gains) and "passive income" (e.g., rental income, interest income, and qualified dividend income).
- The U.S. follows a progressive tax table with seven marginal tax brackets, ranging from 10% to 37%.
Passive Income Activity:
- Passive activity is defined by the IRS as any rental activity or business where the taxpayer does not materially participate.
- Material participation standards include criteria such as contributing more than 500 hours, substantial involvement, and continuous participation.
Passive Income Categories:
- There are two categories of passive activities according to the IRS: business (non-material participation) and rental (covering real estate and equipment).
Short-Term Passive Income Tax Rates:
- Short-term gains (assets held for less than a year) are taxed as ordinary income with rates ranging from 10% to 37%, depending on income levels.
Long-Term Passive Income Tax Rates:
- Long-term passive income is taxed at three levels: 0%, 15%, and 20%, based on income brackets.
Real Estate Income Tax:
- Real estate income tax has specific rules, including a 20% deduction on qualified business income for buy-and-hold real estate.
- Deductions include mortgage interest, depreciation losses, repair deductions, and travel expenses related to property maintenance.
Home Office Deduction:
- Passive income investors working from home can deduct expenses related to their home office, provided they meet specific criteria outlined by the IRS.
Savings from Passive Income Tax Rates:
- Passive income, especially long-term gains, offers potential savings compared to ordinary income tax rates, ranging from 0% to 20%.
In conclusion, understanding these concepts is crucial for individuals earning passive income, as it can significantly impact their tax obligations. Consulting with expert advisors or investment consultants can further optimize tax strategies and contribute to increased returns on investment.