Overview
Passive income includes earnings from investments, rental properties, royalties, and other sources that require minimal active involvement. While passive income can be a great wealth-building tool, it is subject to taxation.
Types of Passive Income & Tax Treatment
*1. Rental Income*
- Taxed as ordinary income after deducting expenses like mortgage interest, maintenance, and depreciation.
- Losses may be deductible under passive activity loss rules.
*2. Dividend Income*
- Qualified dividends taxed at long-term capital gains rates (0%, 15%, or 20%).
- Non-qualified dividends taxed as ordinary income.
*3. Interest Income*
- Earnings from savings accounts, bonds, and CDs taxed as ordinary income.
- Municipal bond interest may be tax-free.
*4. Capital Gains from Investments*
- Short-term gains (held ≤ 1 year) taxed at ordinary income rates.
- Long-term gains (held > 1 year) taxed at 0%, 15%, or 20%, depending on income.
*5. Royalties*
- Income from intellectual property (books, music, patents) taxed as ordinary income.
- Self-employment tax may apply if royalties stem from active business activities.
*6. Peer-to-Peer Lending*
- Interest earned from lending platforms taxed as ordinary income.
- Fees associated with lending may be deductible.
Tax Planning Strategies
- Utilize Tax-Advantaged Accounts: Invest in IRAs or 401(k)s for tax-deferred growth.
- Offset Passive Income with Deductions: Rental property expenses and depreciation can reduce taxable income.
- Consider Holding Investments Long-Term: Lower tax rates apply to long-term capital gains.
- Use LLCs for Asset Protection: Business structures may offer tax benefits.
Common Pitfalls & How to Avoid Them
- Ignoring Passive Activity Loss Rules: Some losses may be limited based on IRS regulations.
- Misclassifying Dividend Income: Ensure correct tax treatment for qualified vs. non-qualified dividends.
- Failing to Plan for Capital Gains: Strategically time asset sales to minimize tax impact.
Tools & Resources
- IRS guidelines on passive activity loss rules.
- Tax calculators for estimating passive income tax liabilities.
- Financial advisors for personalized tax strategies.