What Passive Income Investors Need to Know About Taxes

January 20, 20235 min read
What Passive Income Investors Need to Know About Taxes
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Establishing a passive income stream is something everyone strives for. On top of allowing an individual to potentially retire, every investor dreams of earning money without having to physically work. In other words, it’s a good idea to invest your money so it keeps working in retirement, and when you don’t want to.

Like all income, passive income is taxable, although it can sometimes be taxed differently from active income like wages. With that in mind, here’s what passive income investors need to know about the tax on passive income.

What is Passive Income?

Income is usually categorized into one of two main groups — passive and active. Passive income is typically earned from interest, dividends, capital gains, rental income, etc. Active income is typically derived from wages, salaries, tips, and commissions.

The key difference between the two is that you’ll directly engage in some sort of physical activity to generate active income. Meanwhile, passive income is generated without having to do much additional work, often as a result of an investment in an asset that in turn generates income.

Perhaps, this is the easiest way to look at this: you’ve earned active income if you go to work and receive a salary or perform a service for someone who compensates you in a monetary fashion. Conversely, your earnings are usually considered passive income when a tenant pays rent, an investment earns dividends, or an investment appreciates in value and is sold for a gain…in all of those scenarios you didn’t have to do any active labor.

Types of Passive Income

Self-charged interest, rental income and business investments are a few types of passive income.

Self-charged interest can be derived from loaning money to your own business and paying yourself interest on the loan. According to the IRS, “Certain self-charged interest income or deductions may be treated as passive activity gross income or passive activity deductions if the loan proceeds are used in a passive activity.”

Rental income is also usually considered passive income. However, if you qualify as a real estate professional and materially participate in the rental activity, this could be considered active income per the IRS.

Business investment income is considered passive when you do not materially participate in the business. In order to materially participate in the business, you must satisfy 1 of the 7 tests outlined by the IRS.

Passive Income and Taxation

Generally speaking, passive and active income are subject to similar taxation, except for passive income generated from long term capital gains and qualified dividends. The capital gains tax rate varies depending upon whether the gain is considered long-term or short-term.

Short-term capital gains are taxed at your ordinary income tax rate. Long-term capital gains and qualified dividends are taxed at either 0%, 15%, or 20%, based upon your annual taxable income and filing status. Long-term capital gains typically apply to profits from a capital asset that is held for longer than a year. Profits generated from a capital asset that is held for less than a year are considered short-term capital gains.

Capital Gains Tax Rates for Single Taxpayers in 2023

IncomeShort-Term Long-Term 
≤$11,00010%0%
$11,001 – $44,72512%0%
$44,726 – $95,37522%15%
$95,376 – $182,10024%15%
$182,101 – $231,25032%15%
$231,251 – $492,30035%15%
$492,301 – $523,60035%20%
$523,601+37%20%

Capital Gains Tax Rates for Married, Filing Jointly Taxpayers

IncomeShort-Term Long-Term 
≤$22,00010%0%
$22,001 – $89,25012%0%
$89,251 – $89,45012%15%
$89,451 – $190,75022%15%
$190,751 – $364,20024%15%
$364,201 – $462,50032%15%
$462,501 – $553,85035%15%
$553,851 – $693,75035%20%
$693,751+37%20%

Passive vs Active Income Tax

Active income is also referred to as “earned income”. Active income is taxed based upon where it falls within the seven Federal tax brackets. These range from 10% in the lowest bracket to 37% in the highest tax bracket.

Passive income and active income are both taxed in the same manner, with the exception of long-term capital gains and qualified dividends being taxed at beneficial tax rates. In fact, your tax savings could ultimately be about half of what you’d pay against ordinary income if you’re earning a long-term capital gain or qualified dividend income in the top tax brackets.

But there is something else to consider when it comes to passive vs active income tax. Passive income derived in the form of interest income from municipal bonds is generally tax-free for Federal tax purposes. Federal taxes generally cannot be applied to interest income from municipal bonds. There are a host of other passive income tax advantages to consider as well. To get an idea of where your investment will place you in this regard, you can use an online excess net passive income tax calculator, such as the one offered by Money Tools.

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Passive Income Streams

As you may have gathered, many sources of passive income streams are pretty self-explanatory and there are many potential tax advantages.  With that said, business/investment income does bear a bit more attention because it can lead to a wider variety of possibilities.  Of course, you should consult with a tax professional for advice specific to your situation.

In addition to direct investments in businesses, in which you afford the owners use of your capital, you can also invest in other opportunities outside of the stock market, such as private investment opportunities. Investing with Yieldstreet for example gives you an opportunity to generate passive income with alternative investments. These investments, often in private markets and alternative asset classes, typically have low stock market correlation and cover a broad range of asset classes. Many of these deals are backed by underlying collateral and range across art finance, real estate, commercial finance and legal finance, asset classes that historically had been closed off to retail investors.

Historic target yields have been in the range of 7% to 15%, depending upon the opportunity. Even better, Yieldstreet offerings have predefined payment schedules, which are outlined upfront on the offering page of the investment offering documentation, as well as in the Series Note Supplement or Investment Memorandum.

Here’s how you can start generating passive income today with Yieldstreet.

Final Thoughts

In conclusion, establishing a passive income stream can provide financial security and flexibility in retirement or at any point in life. Passive income can come from a variety of sources, such as interest, dividends, rental income, and capital gains. Capital gains and dividends can sometimes be more tax advantageous than the tax rules for earned income.

However, it’s important to consult with a tax professional to determine the best strategy for your unique circumstances. Investing in alternative investments, like those offered by Yieldstreet, can also provide opportunities for generating passive income with potentially high yields and predefined payment schedules.

By understanding the basics of passive income and taxation, investors can make informed decisions and create a path to financial freedom.

Please note:  Yieldstreet does not provide tax advice and this article is for illustrative purposes only and is not intended to be – and should not be construed as – tax advice. Please consult a tax professional for advice specific to your situation.

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