More and more people are talking about generating passive income. Capital gains, interest income, passive income from rentals, and other sources of passive income are all seen as more desirable than ordinary income, and for good reason.
After all, having income you don't need to do anything to get, income that's coming in even while you sleep, sounds like a dream come true.
However, there are some downsides to passive income, just like ordinary income, and it's important to know how passive income taxed and how you'll need to pay taxes on your portfolio income and other sources.
In this post, I'll explore what passive income is, the passive income tax rate, and much more. Let's get started!
2022 Passive Income Tax Rates
Taxes on passive income will ultimately depend on the type of income you generate and your total income for the year.
Below are the tax rates for 2022. Always consult a tax professional before making any decisions.
What Is Passive Income?
First, you need to know what really counts as passive income and what's ordinary income.
For instance, capital gains are considered passive income. Royalties, rental income, and other sources of capital may be passive, or they may not be, depending on how you're earning that income and how much work you're putting in to maintain it.
But investment income is often considered passive, even if you're working hard on your portfolio to generate that investment income.
There are also differences between long-term capital gains and short-term capital gains, which can make a big different in how you pay tax, your tax bracket, and which tax deductions you potentially quality for.
Currently, the IRS considers rental income, or any income from activity or business in which the individual receiving the income did not materially participate is passive income.
There's a big difference between passive income and active income.
What Does Materially Participate Mean?
Material participation is the key to passive income taxes.
Here's what you need to know to decide if you've materially participated in the business earning income for you.
According to MarksPaneth, material participation means:
You've spent 500+ hours working toward the goals of the business in the last year.
Your participation in the business or venture is ‘substantially all' of the participation, which means that you did everything that resulted in income from that source.
You materially participated in the business venture for at least 5 of the last 10 years.
OR in personal services businesses, you materially participated for 3 previous tax years.
If you meet any of those criteria, you were a material participant in the business venture and your income is probably ordinary income not passive income.
Why Are Different Kinds Of Income Taxes Differently?
There are a lot of reasons that different types of income are taxed differently, but the exact reasons behind each tax rule have specific reasons.
A lot of people avoid paying taxes when they can, but the tax rate and the amount of tax paid by compliant individuals matters. Your income earned is a big part of this.
Taxes are about making sure the country is running properly and that we're meeting the general goals of the country, like ensuring the roads are paved, mail is delivered, children are educated, and civilians are protected.
That being said, earned income tax and other tax rates are determined, in part by how people who have that kind of income are expected to participate in the economy.
There's good and bad news here. Some kinds of income, like short-term capital gains tax, might be more heavily taxed, while other types of income benefit from preferential tax rates and more tax breaks designed to help encourage that kind of economic activity.
Why Are Capital Gains Different Than Ordinary Income
Capital gains are treated as different from other kinds of active income for a few reasons.
For one thing, without a capital gains tax, it would be possible for people to focus on long-term capital gains and buying and selling capital assets as a source of income that would be potentially untaxable.
But this kind of economic activity isn't the same as ordinary income and treating it like ordinary income with a flat income tax wouldn't be fair and would have widespread tax implications.
So, instead, the buying and selling of capital assets, like your home, car, rental properties, or other substantial assets have their own tax rate and tax rules.
Usually, long-term capital gains are things like the money you make when you sell your home after owning it for years, or when you sell an investment position after holding on to it for a long time.
Short-term capital gains are usually things like flipping houses, selling short-term investments for quick income, and short-term capital gains are more heavily taxed in almost all circumstances than long-term capital gains.
For many people, they've already paid income tax before being able to make a capital gain sale or purchase, so having a lower tax rate on this kind of capital gain is better for avoiding taxing the same income too many times.
Is Social Security Income Passive Income?
Social security is an interesting tax problem when it comes to income and how you'll need to pay taxes.
For one thing, your social security tax rate depends largely on your annual income. Social Security isn't considered passive, instead it's a form of earned income. Therefore, there are different tax brackets depending on how much you're earning from Social Security and other sources.
The more income you have, the more of your social security is subject to taxation. So, if you have high enough annual earnings up to 80% of your social security payments may be taxable.
That doesn't mean that 80% of your social security payments will be paid in taxes, but rather that 20% of your social security income won't be taxed at all, and the rest will be taxed using the applicable earned income rate.
What About Rental Income, Royalties, And Other Passive Income Sources?
One of the key takeaways passive income is usually less taxed than earned income, and real estate investors and others need to be aware of passive income tax rates.
This is important because passive activities, like investing in real estate, fall under different tax rules than other kinds of real estate income.
Royalties, on the other hand, might be passive under the normal definition but are treated as a different kind of income for tax purposes. For instance, if you publish a book and don't revise it, but earn royalties for years afterward, that's supplemental income not passive.
However, royalties from oil or mineral rights might be taxed slightly differently. They're always going to be considered income, but rarely passive income for tax purposes.
This type of income is almost always complicated, so you'll likely want to consult with a tax expert to make sure you're paying the right rate of taxes, and that you know what kind of income you're getting from different sources.
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Why Does How Much You Earn Matter For Passive Income Taxes?
If you're familiar with the passive income tax rate you'll already be familiar with the fact that, like other income, passive income has multiple tax brackets based on how much you earn.
Those tax brackets change when new tax laws are written, depending on what the primary goal of that version of the tax code is. Right now, passive income is taxed anywhere between 10-39.6% depending on what tax bracket you're in.
Remember, tax bracket is based on total annual income, not passive earnings alone. So if you have a small amount of passive earnings each year, but earn a large annual income from active sources, your passive income tax rate will still be higher.
Why do tax brackets work this way?
Well, there are a couple of reasons for different tax brackets, but the core idea is that people who have access to more resources should contribute more to society at large, while people who have access to fewer resources should still contribute some, but shouldn't be as burdened bu the needs of society as a whole.
Basically, the less you earn the more important it is for you to keep your earnings, and the lower tax rate you'll have to pay. The more you earn, the more you can afford, and the more you're likely to have benefited from society's perks (like drivable roads and an educated population for your workforce) and therefore the more you should pay to help support it.
In reality tax breaks and deductions often change the effective tax rate on your income as much or more as your tax bracket.
Passive earnings are treated the same way as other income, so the more you've earned elsewhere (or through passive earnings) the larger percentage you'll potentially have to pay in your effective tax rate.
Passive Income Tax Breaks
If you're making passive income and having to pay passive income tax, there are a few tax breaks you should know about.
These tax breaks aren't the only options out there, of course, a tax professional may be able to find additional tax breaks and loopholes that will further reduce your taxable income, passive or active.
That said, these are still important tax breaks and you should make sure you're using them if you have qualifying taxable income.
This is a 20% deduction of pass-through taxable income that you may qualify for if you're part of an LLC, sole proprietorship, or S-Corp. This option lets you pass some of your taxable income on to the owner of the corporation, which means that they'll pay taxes instead of you.
This pass-through rule is a good way to make significant savings on your passive income or any income from your small business involvement that's considered passive income.
That includes things like income on a rental property that goes through an LLC, or other businesses that run through an LLC before you get your share of the income.
Section 121 Section 1031 Real Estate Tax Break
This deduction applies specifically to real estate tax, and is important if you sell a profitable property, rental property, or another real estate holding.
If the owner of the property has lived in it for 3 out of the last 5 years (which leaves 2 years where you could have rented the property) you'll qualify for section 21. This deduction lets you only pay taxes on a portion of the profits from the sale of the property.
If the property you're selling is specifically a rental property you'll be able to use a 1031 exchange to reduce the amount of income that gets taxed from the sale.
You'll do this by using some of the profits from the sale to buy a separate rental property.
100% Bonus Depreciation (Section 179)
The 179 bonus depreciation deduction is designed to help protect people from losses when their assets depreciate within the first 20 years of ownership.
Home improvement projects are often considered an asset in this case, as are renovations, or other investments into a physical product or building that then loses value quickly and unexpectedly.
You'll need to consult with a tax expert to figure out what qualifies for the 100% bonus depreciation deduction.
However, qualifying expenses can be 100% written off on your taxes, the first year the depreciation happens. This can reduce your passive income taxable under the current federal income tax code, and can be used to help control your tax brackets when you have qualifying assets.
Final Thoughts on Passive Income Taxes
The passive income tax rate will ultimately depend on your tax bracket based on your overall income.
This rate can be anywhere from 10% to 37%, based on your income level.
Before making any decisions, always consult a tax professional for the best advice.
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