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Passive Income and Your Taxes – What You Need to Know

Passive Income and Your Taxes – What You Need to Know

If you receive revenue from a passive income stream—for example, from a blog that you write, a rental property that you own, or an investment portfolio—it’s important to be aware of this money will be taxed. Understanding the tax implications of your passive income will help you make the most of this revenue, and hope you avoid any fines or penalties that might result from filing your taxes incorrectly.

Here are some important things about passive income to keep in mind when tax season rolls around:

The IRS divides income into three major categories.

According to the IRS, there are three different types of income. Each type is reported in a different section of your tax return, and may be subject to different amounts of tax. Understanding where the money from your various passive (and other) income streams fits in will help you file your taxes correctly. These types are:

Active income—Also known as earned income, active income is what most people associate with the term “income.” Broadly speaking, this is money that you earn from working. It can be wages or salaries earned from an employer, tips and bonuses, income from participating in a business, and income from self-employment or through work done as an independent contractor. Active income also includes alimony payments and some forms of retirement income.

Investment income—The IRS considers income that you earn from investments as its own separate category, which is also known as portfolio income. This income may take the form of interest, capital gains, and/or dividends: each of these categories has a different set of tax rules. The most important thing to note here is that the IRS views investment income as distinct from passive income, even though popular opinion generally holds that investment income is a form of passive income.

Passive income—The IRS definition of passive income is somewhat vague, but in essence, passive income is considered to be any money that is not related to wages, business activity, or investments. In other words, it’s money that comes from what the IRS refers to as a “passive activity.” Royalties or money made from licensing patents walls into this category (Once again, note that the IRS specifically excludes portfolio and investment income from the passive income category.)

There are precise rules around what constitutes a “passive activity.”

According to the IRS, a passive activity refers to any business in which you don’t materially participate. Under IRS rules, you are considered to be a material participant in a business or activity if you have spent more than 500 hours during the year working in the activity; if you were the business’ sole participant during the year; if you worked at an activity during the year as much as any other individual in the business (provided this amount was at least 100 hours); if your work time on all passive activities exceeded 500 hours, with at least 100 hours at a single activity; and if you were a material participant in the activity in at least five tax years of the previous 10.

The point of these criteria is to distinguish whether you were earning income from a business or activity as a business owner or simply as an investor, and therefore to determine whether your income should be considered active or passive (and taxed accordingly).

Real estate has its own set of rules.

Another interesting exception to note concerns rental real estate. In most cases, income that you earn from rental real estate (as well as dividend income from real estate investment trusts) is treated as passive income rather than active income.

Rental real estate is only considered to be an active business if you meet strict IRS standards for real estate professionals. These include providing a minimum of 750 hours of service and the requirement that at least half of all personal services you provide be in the real estate category.

Passive income is usually taxed the same as active income.

In general, most passive income is taxed in the same way that active income is. However, different rules apply when it comes to loss deductions (this is the main reason why passive income constitutes a separate IRS category and isn’t lumped in with either active or investment income). In particular, the IRS does not allow passive losses to offset your active or your investment income.

If you have losses or are able to make deductions via a passive activity, these losses are only deductible against other passive income. In other words, you can’t use passive losses to help you pay less tax on your other forms of income. In addition, passive losses must be carried forward rather than claimed immediately.

If this seems confusing, it’s helpful to keep in mind that the purpose of these passive income tax rules is to prevent taxpayers from investing in passive activities simply in order to claim losses and thus reduce their overall tax burden. Encouraging taxpayers to invest in profitable passive activities—thus boosting individual income and tax revenue alike—is the overall goal here.

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