Income taxes are a part of life. Most working adults pay them for the majority of their lives. That means it is essential to understand what your tax obligations are.
At Cook Martin Poulson, one of the most common questions we get about income taxes is this:
Do I need to pay taxes on passive income?
People can sometimes be confused about the tax on passive income. In this article, we review the passive income tax rules, talk about the tax benefits of passive income, and give you all the information you need to calculate and pay taxes on your passive income.
What is Passive Income Tax?
Active income is money you earn in return for the work that you do. If you own a company, work for a company, or work for yourself, then you earn money or active income, for your labor.
By contrast, passive income is money you earn outside of work. A very simple example would be the interest you earn on a savings account. You don't do any work for that money, but it is still considered income. The same is true of dividend payments and rental income.
Passive income tax is the tax you pay on money that you earn outside of your job or side gigs where you do work in return for money. If you have a hobby that generates money, that's not passive income because you do work in return for that money. Truly passive income is income that you receive without doing work.
How Does Passive Income Work?
People earn passive income in a variety of ways, some of which we have already mentioned. If you have a money market account, the interest you earn is passive income. You might also earn passive income if you have a website that displays ads and receives money when people click on those ads.
The key difference between passive and active income is what you do to earn it. If the answer is "nothing," then it's passive income. Passive income may be earned at any time of the day or night, even if you're asleep or on vacation. You may have done some work to create passive income streams; but once they exist, there is no work required to earn the money that is generated by them.
What Are the Benefits of Passive Income?
There are significant benefits to earning passive income, including some passive income tax benefits.
In terms of your finances, passive income is wonderful because it offers you a chance to earn more money than you could from your job and without doing additional work. If you have money in a savings account or you buy a stock that pays dividends, you can add to your annual income and improve your standard of living.
There are also some benefits to consider from a tax standpoint. Most apply to passive income rental property tax. While the money you receive as rent is, in theory, taxed at the ordinary rate, you may deduct depreciation, amortization, and rental expenses, thus reducing your effective tax rate. We will talk more about these deductions later in this post.
Is Passive Income Taxable?
The question of whether passive income is taxable is one we hear a lot at Cook Martin Poulson. Some people believe that they only need to report the income that appears on their W-2 form and that belief can cause them trouble both with the Internal Revenue Service and state taxing agencies.
The short answer is that all income is taxable unless tax law specified otherwise. It doesn't matter whether you earned money from the job you do every day or from an account that pays interest or dividends. You are required to report that income to the IRS and pay taxes on it.
However, the answer is also more complicated than you might think. While it is true that in many cases, passive and active incomes are taxed at the same rate, there are exceptions.
The safe assumption is that most types of passive income are taxed at the ordinary tax rate, which is what is used for active income. Tax planning for passive income should include an itemization of passive income sources to ensure that you report everything.
What is the Tax Rate on Passive Income?
What is the IRS passive income tax rate? The simplest explanation is that in most cases, passive income is taxed at the ordinary income tax rate. As its name implies, the ordinary income tax rate is the most common rate. It is used for active income, including the money you earn from your employment and any side gigs you may have.
To give you an idea of how passive income might be taxed and what the rates are, let's look at an example. A single person whose adjusted income was $90,000 in 2020 would pay about $15,686 in federal income taxes. That amount works out to approximately 17.43%.
If that person also earned $1,000 in ordinary dividends, those would be taxed at the ordinary tax rate of 17.43%. The same is true of bank interest or interest from a money market account.
One difference is what happens with income generated by real estate. While the income is taxed, rental property depreciates over the 27 to 39 years from the time of purchase. You may use depreciation and amortization to lower your effective tax rate. For example, if you earned a rental income of $20,000 and deducted $12,000 in depreciation and amortization, you would pay taxes on only $8,000. Even if you paid the ordinary tax rate of 17.43% from our example, the total tax you paid for that income would be $1,394.40. When you compare that to your actual income of $20,000, the effective tax rate on that income is only 6.97%.
How Is Passive Income Taxed?
Reporting passive income can complicate the process of filing your taxes. If you earn significant passive income, you will receive multiple forms before filing your taxes. For some forms of income, such as real estate income, you will need to maintain your records to report what you earn to the IRS.
Here are some of the tax forms you may receive and/or need to file to figure out your taxes for passive income.
- Form 1099-DIV is used by banks and financial institutions to report income earned from dividends.
- Form 1099-INT is used to report income earned from interest.
- Schedule E (Form 1040) is used to report income from rental properties.
Is Passive Income Subject to Self-Employment Tax?
Another common question related to passive income tax is whether the income you earn from passive income streams is subject to self-employment tax. The self-employment tax rate includes both the employer's and the employee's share of Medicare and Social Security taxes, making the effective tax rate for the self-employed higher than for those who work for others.
According to the IRS, self-employment income includes the following:
- Money you earn from a trade or business you own as a sole proprietor or independent contractor.
- Money you earn from a partnership that carries on a trade or business.
- Money you otherwise earn while in business for yourself, including part-time work.
You will notice that these definitions do not include interest, dividend payments, or rental income. That means that while you are required to pay taxes on your passive income as defined by the IRS, you do not need to pay the self-employment tax on it.
Examples of Passive Income for Tax Purposes
To help you better understand passive income and how it will impact your income taxes, let's look at some examples of passive income for tax purposes. You should be aware of what is classified as passive income and whether you need to report it as such to both the IRS and your state taxing agency. Here are some of the most common examples of passive income:
Rental Properties Income
If you own rental properties, then the money that you collect as rent is counted as passive income by the IRS. The rules can be complex, but generally, you need to report your income when you earn it. This includes the following:
- Regular monthly rent
- Rent paid in advance (first & last)
- Pet rent
- Fees for amenities such as a parking space
You will note that we have not listed security deposits. If you collect a security deposit or a pet deposit, it is your responsibility to hold it in trust on behalf of your tenant. You do not need to report it as income unless you keep part of the deposit to offset damage to a rental unit. In that case, you need to report anything you retain.
Real Estate Investment Trust (REITs)
Real Estate Investment Trusts, or REITs, are investment vehicles modeled after mutual funds. The primary difference is that instead of investing in stocks and bonds, REITs own and operate real estate used as rental properties.
The income you earn from investing in a REIT is considered passive income and is taxable. Most REIT dividends are taxable at the ordinary income tax rate, which caps out at 37%. You may also be required to pay a 3.8% surcharge on investment income, but you can deduct up to 20% of the combined qualified business tax, including the income for qualified REIT dividends.
A Bond Ladder
Bond ladders are bond portfolios featuring bonds with different maturity dates. As an investment strategy, bond ladders are useful because they diversify your portfolio and spread out both income and risk.
As your bonds reach maturity, you may choose to cash them out or roll them over into a new investment. If you cash them out, which many people do as a way of supplementing their income, the money you earn is considered passive income and will be taxed at the ordinary tax rate.
Keep in mind that depending on the types of bonds you buy, you may receive Form 1099-INT to report interest. If you do, you are required to pay taxes on that interest even if you have not received it.
Buying dividend stocks is a good way to supplement your income while also investing for the future. Dividends are most often paid quarterly or annually, and you will need to report your dividend earnings to the IRS as income.
When you receive dividend payments, you should get Form 1099-DIV from your bank or financial institution. You need to report that income on your Form 1040 when you file your federal income taxes.
You should be aware that not all dividends are taxed in the same way. Ordinary dividends are taxed at the ordinary tax rate. However, qualified dividends may be taxed at the capital gains tax rate, which is generally lower than the ordinary tax rate. Here's how the capital gains tax rate breaks down for 2020:
- If your taxable income is less than $80,000, you may be exempt from the capital gains tax, or you may need to pay taxes on some of your capital gains at a rate of 15%.
- If your taxable income is between $80,000 and $441,450 if you're single, or $496,600 if married and filing jointly, your capital gains tax rate is 15%.
- If your taxable income exceeds the threshold for the 15% rate, then most capital gains are taxed at 20%.
There are a few exceptions where the capital gains tax rate is higher. For example, if you were to sell small business stock as defined in Section 1202, the capital gains tax rate is 28%.
High-Yield Savings Accounts
High-yield savings accounts offer a low-risk way to set money aside for retirement or other long-term goals. A savings account is classified as "high yield" if it pays between 10 and 25 times as much interest as a traditional savings account. For example, a regular savings account might pay .05% interest, meaning that with a $10,000 deposit, you would earn $5 a year in interest.
By contrast, a high-yield savings account might pay .7% in interest, meaning that with the same deposit, you would earn $70. For taxation purposes, the interest from a high-yield savings account is considered passive income and is taxable at the ordinary tax rate.
What happens if you own part of a company, and you lose money as a result of passive activity? Passive activity income is defined as money you earn when you passively participate in a business. In other words, passive activity income is money that you receive despite a lack of material participation.
For example, if someone puts money into a company in return for interest, the individual may be allowed to deduct money as a passive activity loss in some circumstances.
The issue of passive activity loss is a complex one and is best handled by a tax professional who understands the tax code as it relates to passive losses.
How to Report Passive Income on Tax Return?
Reporting passive income can be confusing because, if you have multiple passive income sources, you need to use a variety of forms to report it. Here are some of the most common examples:
- If you received taxable income from interest, reported on Form 1099-INT, you must report it on Schedule B of Form 1040.
- If you received taxable passive income from dividends, reported on Form 1099-DIV, you must report income from qualified dividends on Line 3a of Form 1040, and income from ordinary dividends on Line 3b of Form 1040. If you earn more than $1,500 in dividend payments during the tax year, you will also need to file Schedule B.
- If you received taxable passive income from rentals, you would report it on either Form-1040, or Form 1040-SR, Schedule E, Part 1.
- If you are claiming passive activity losses, you will use Form 8582.
If you have a lot of passive income to report from many different sources, there may be additional forms required. People who have high income and diversified investments may find that they require help preparing their tax returns and reporting passive income.
Our Tax Pros Can Help Minimize Your Passive Income Taxes
It is common for people to overpay their income taxes on passive income because they don't understand the deductions that apply to them and how to claim them. The best way to avoid overpaying and to minimize your passive income taxes is to work with a tax pro who has the experience and expertise to help you avoid paying unnecessary taxes.
Do you need assistance in preparing your income taxes and reporting passive income? Cook Martin Poulson is here to help! Contact us today to learn about our income tax services and schedule a free consultation.