If you are in the working class or the business class, you must have paid taxes on some occasions. However, what if you are not working?
What if the bulk of your money comes from past investments? Do you still get taxed for this? The answer is yes.
The IRS has a modality for taxing passive income, and you should learn about the passive income tax rates and how it works.
The knowledge you gather from this article will guide your decision on what to look out for when choosing your passive income and how to position yourself to take advantage of tax benefits.
It is important to mention at this point that learning these things doesn’t make you an expert. You still need to hire a CPA to guide you through the process. Note that this article does not substitute for the expertise of a CPA. With that said, let us dive right in.
What is Passive Income?
Many people have a different opinions of what passive income means. Some people assume that gifts from friends and family qualify as passive income. Some people think that inheritance passes as passive income.
However, the IRS is the sole authority that can decide what passive income truly means. Therefore, let us take a moment to review how IRS defines passive income.
The IRS mentioned over 20 different types of income in their list. However, we can narrow all these income types to three categories: portfolio income, passive income, and generated income.
In summary, earned income is any income that requires direct physical input of time over a particular period. Portfolio income is a type of income gained through sales or holding of assets. E.g., stock dividends, bond interest payments, and capital gains through sales of securities in a portfolio.
The IRS considers income passive if it is earned from rental activity or a business that the taxpayer does not materially take part in, such as royalties, shares of a limited partnership, and rental real estate.
According to the IRS, material participation is judged by:
You being the sole operator of the business throughout the year
You working for a minimum of 500 hours in 1 year
Putting in at least 100 hours as much as anyone else within the year.
And some other criteria.
If you engage in any of the listed capacities, the income you generate from this kind of business is grouped under “active income” and incurs the same tax rate as personal income tax.
Those capital gains that come from holding assets or selling assets fall under passive income, and the IRS categorized them into two categories: short-term gains and long-term gains. These two kinds of passive income get taxed at different rates.
Other Passive Income Tips
What is the passive income tax rate?
The passive income tax rate is the yardstick that the federal government of the United States uses to decide the tax placed on the passive income of citizens. This tax rate varies based on the term of the income.
The long-term passive income tax rate differs from the short-term passive income tax. The table below shows the tax rate for income ranging from thousands of dollars to hundreds of thousands of dollars.
Short-Term and Long-Term passive income Tax Rates for Single Taxpayers
| Income | Short-Term Capital Gains Tax Rate | Long-Term Capital Gains Tax Rate |
| ≤$9,950 | 10% | 0% |
| $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% |
| $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% |
| $523,601+ | 37% | 20% |
How passive income tax rate works
When you hold an asset for less than 1 year, the IRS regards it as a short-term capital gain. While it is called long-term capital gain if you hold the asset for longer than one year. The short-term capital gains tax rate is equal to your applicable federal marginal income tax rate, and the Long-term capital gains tax rate depends on your income range
The 2018 tax reform shifted the tax advantage to long-term passive income holders. In the range of $209,426–$445,850 in passive income, there is a difference of 20% in long-term passive income compared to short-term passive income.
If you are looking to marginalize your passive income tax, it pays to opt for the long-term capital gain so that you can reduce the percentage tax on the larger capital gain.
It is critical to note at this point that you must take specific steps to ensure that your capital gain falls within the timeframe for long-term capital gain.
In order to benefit from the IRS tax treatment. You need to ensure that your total passive income enters the $40,400 mark. At this point, you can enjoy a total of 0% tax rate on your long-term capital gain.
Conclusion
There is no need to pay exorbitant rates on your passive income, especially if you are retired, and living off your passive income.
If you follow the simple ideas laid up above, and you spend time with a great CPA, you should be able to take advantage of all the benefits that come with long-term passive income.
This doesn’t mean you can’t augment your long-term strategy with a short-term strategy. You have to decide how it works best in your favour.
But before you go all out to take advantage of all these tax benefits, here are some things we discussed in the article that you must bear in mind.
First, Your passive income comes from sources where you earn without your material presence. Your material presence means that you spend less than 500 hours of active involvement with the business or source of income per year.
Gifts from family and friends do not count as passive income.
Second, a long-term strategy outperforms a short-term benefit by 20%. Long-term capital gain is defined as any capital gain that you hold for longer than 1 year, while short-term capital gain is any capital gain on an investment that is held for shorter than 1 year. Now you know enough to help you decide. Talk to your CPA, and take advantage of tax benefits.