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Passive Income Taxation Cheat Sheet

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

  1. Utilize Tax-Advantaged Accounts: Invest in IRAs or 401(k)s for tax-deferred growth.
  2. Offset Passive Income with Deductions: Rental property expenses and depreciation can reduce taxable income.
  3. Consider Holding Investments Long-Term: Lower tax rates apply to long-term capital gains.
  4. 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.