How Is Passive Income Taxed: All You Need To Know

Editorial team of TFX

• 17.08.22 • 5 min read

Are you looking for a way to increase your income without working harder? Using passive income to generate income can allow you to earn money while you sleep, seven days a week.

The main types of income are active income, passive income, and portfolio income, which fall into three different categories. The IRS defines passive income as income that is generated by activities that you do not participate in materially. In other words, you make money without being active in your company's day-to-day operations or taking part in its day-to-day management. There are, however, some tax implications to be considered when it comes to this form of income, just like any other.

What Is Passive Income?

What is passive income for tax purposes? Passive income refers to earnings that originate from properties leased, limited partnerships, or other businesses where a person is not actively involved. The Internal Revenue Service (IRS) often treats passive income differently than active income when taxing it.

How Passive Income Is Taxed

Passive income can be generated through a range of investments, including dividend stocks, exchange-traded funds, dividend index funds, bonds, bond index funds, rental properties, or even high-yield savings accounts. In addition, there are other options that you can consider for an investment, including peer-to-peer lending platforms (where you can earn self-charged interest), real estate investment trusts, or even becoming a silent partner in a business (without participating materially).

Many people with incomes can benefit from passive income methods that do not cost much and are within their grasp. Your monthly income may not be affected by these methods in the short term, but they can help you build up your retirement savings. Most people cannot afford the initial investment it takes to make passive income that's sufficient to quit their day jobs and live on.

Those who promote passive income tend to advocate working from home and being your own boss. Recent years have seen a relatively loose use of the term passive income. In the figurative sense, money earned in a regular manner without any effort on the part of the receiver is considered passive income.

Type Of Passive Income

A passive income is earned when a person receives interest from self-charged accounts, rents from rental properties, and does not materially participate in businesses that generate it. To be considered passive income, specific IRS rules must be followed.

The IRS Publication 925 identifies two types of passive activities:

• A business or trade activity in which you do not have a material interest.
• Rental activities associated with rental properties (even if you materially participate) except for those that are directly related to your real estate duties.

Self-Charged Interest

An owner of a partnership or S corporation can qualify for passive income when he or she lends money to the partnership or S corporation acting as a pass-through entity. The S corporation or a partnership such as this is essentially a business whose purpose is to minimize the effects of double taxation. Depending on whether the loan proceeds are used in a passive activity, certain self-charged interest income or deductions may be treated as passive activity income, according to IRS rules.

Rental Properties

Apart from a couple of exceptions, rental properties are considered passive income. Rental income is considered active income if you're a real estate professional. Self-renting, which means renting out your own space to a company or partnership where you conduct business, is not considered passive income. Therefore you are exempt, so you don't have to declare it as such.

The income derived from leasing land is also not eligible for inclusion in passive income calculations. Passive income loss rules, however, can benefit landowners if the property nets a loss.

Is Passive Income Taxable?

The income you earned from passive activities is taxable, just like income earned from full-time employment. Any passive income earned from a property or interest in a passive income activity must be reported as income to the Internal Revenue Service. How is passive income taxed?

You owe taxes based on a variety of factors, including whether you made passive income from the business and how much time you spent on it. The tax treatment of rental income differs from that of earnings from businesses or trades and from rewards earned from cash-back credit cards. A professional can help you understand your specific tax situation if you have passive income from various sources.

Before you take advantage of passive income opportunities, it may be a good idea to consult with an accounting professional to ensure that you fully comprehend the potential tax consequences so that you will be prepared when tax time comes around. Besides that, they can also provide you with more information on recordkeeping and the types of documents you may be required to submit with your tax return.

Passive Income Tax Rate

To file a tax return, there are four types of filers: single taxpayers, married couples filing jointly, head of households, and married couples filing separately.

Short-term capital gains are taxed the same way you would at your regular income. Currently, short-term gains are taxed at different tax rates based on tax brackets: 10%, 12%, 22%, 24%, 32%, 35%, and 37%.

The term long term refers to assets held for longer than a year. Long-term capital gains are taxed at three rates depending on your income level: 0%, 15%, and 20%. Investments held for an extended period have many tax advantages over investments held for a short period of time.

Passive Income Streams

There are a few opportunities available to you if you are interested in earning passive income quickly and without spending a lot of time or money:

• A passive income source such as dropshipping can be very profitable. On marketplaces like AliExpress, you can sell trending items to customers in many countries using drop shipping. Fashion, home decor, or beauty items are just a few of the dropshipping niches you can sell on your online store.
• Online courses can be a great source of passive income for those with expertise in some subject areas. There are plenty of people who are willing to pay for access to your content, regardless of whether you sell them on your website or through online learning platforms like Udemy.
• The blogging industry is another popular source of passive income. As a result of blogging, countless entrepreneurs have built passive incomes by selling products, promoting affiliate links, offering courses, promoting sponsored posts, or taking advantage of book deals.
• Become an affiliate marketer. Affiliate marketing is an excellent way to make money if you already have a website with a large following. To earn money, you will need to figure out how to market the product or service.   
• Set up an investment fund. Passive income can be earned by investing in stocks and bonds. Make sure you have an emergency fund, retirement fund, and minimal debt before you consider this as a passive income method.
• On the Internet, you can sell unwanted items. Online marketplaces may be able to help you sell items you no longer need or want. You may have to pay a small listing fee in some cases, but you may be able to post for free in others. 
• Consider downloading an app that offers coupons or cash back. Save big on groceries and household items with coupons from sites like Coupons.com and RetailMeNot. 
• Your credit card can earn you cash back. Credit cards that offer cash back rewards can be used for everyday purchases. 

Rent out a spare bedroom in your home. Do you have extra space in your home that you don't use often? Create a listing on Airbnb or a similar service to rent it out and streamline the payment process. You can also hire a cleaning service to tidy up the space between rentals, although this may affect your profit.