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.
Income can be classified under one of two headings — passive and active. Passive income is earned from interest, dividends and payment from rental property. Active income is derived from wages, salaries, tips and commissions.
The key difference between the two is you’ll directly engage in some sort of physical activity to generate active income. Meanwhile, passive income is generated without having to do any 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 considered passive income when a tenant pays rent, an investment earns dividends, or a company in which you participate as an investor pays you interest…in all of those scenarios you didn’t have to do any active labor.
Self-charged interest, rent/lease payments and business investments are three common 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.”
Rent/lease payments derived from real estate you own are also considered passive income, unless you’re renting a space you own to a business in which you are an active participant. The exception to this is the lease must have been signed prior to 1988, in which case the proceeds are then considered to be passive. One more caveat, land must be developed in order for the income derived from leasing it to be considered passive, except in instances in which the property nets a loss for a given tax year.
Business investment income is considered passive when your participation in the business is limited to the investment of capital. This includes helping the owners manage the company, as that can be looked upon as a form of material participation.
Generally speaking, the taxation of passive income falls under the heading of capital gains taxes. The passive income tax rate varies depending upon whether the gain is considered long-term or short-term.
Short-term capital gains are taxed at the marginal income tax rate. Long-term gains are taxed from 0% to 20%, based upon your annual taxable income, marital status and filing status. These are paid on profits from an asset held for longer than a year. Profits generated from an asset held for less than a year are considered short term.
The following tables illustrate the tax rate differences.
Capital Gains Tax Rates for Single Taxpayers
|$9,951 – $40,400||12%||0%|
|$40,401 – $40,525||12%||15%|
|$40,526 – $86,376||22%||15%|
|$86,377 – $164,925||24%||15%|
|$164,926 – $209,425||32%||15%|
|$209,426 – $445,850||35%||15%|
|$445,851 – $523,600||35%||20%|
Capital Gains Tax Rates for Married, Filing Jointly Taxpayers
|$19,901 – $80,800||12%||0%|
|$80,801 – $81,050||12%||15%|
|$81,051 – $172,750||22%||15%|
|$172,751 – $329,850||24%||15%|
|$329,851 – $418,850||32%||15%|
|$418,851 – $501,600||35%||15%|
|$501,601 – $628,600||35%||20%|
As you can see, in every circumstance it pays to hold onto investments for the long term, as the tax rate is often considerably lower. In fact, depending upon your income, you may have to pay no tax on your passive income at all.
Active income is referred to as “ordinary income” in the IRS tax codes. Taxable treatment is applied to ordinary income based upon where it falls within the seven tax brackets. These range from 10% in the lowest bracket to 37% in the highest tax bracket.
Meanwhile, passive income is taxed according to the capital gains rules we outlined above, from 0% to a maximum of 20%. This treatment proves advantageous in terms of shielding your income from excessive taxation in every circumstance when compared to the rules applied to ordinary income. In fact, your tax savings come to about half of what you’d pay against ordinary income if you’re earning a qualified dividend income in the top tax brackets.
But something else to consider when it comes to passive vs active income tax: Passive income derived in the form of interest payments from municipal bonds is completely tax-free. Federal taxes cannot be applied to interest payments 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.
As you may have gathered, many sources of passive income streams are pretty self-explanatory and the potential tax advantages are many. 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.
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.
Yieldstreet provides access to alternative investments previously reserved only for institutions and the ultra-wealthy. Our mission is to help millions of people generate $3 billion of income outside the traditional public markets by 2025. We are committed to making financial products more inclusive by creating a modern investment portfolio.