How Is Passive Income Not Taxed

The term passive income was made popular in the 1990s when online shopping took off and people started generating revenue from their websites. Since then, it has grown into something much more powerful – creating sustainable, recurring revenues that allow you to spend your time doing other things!

Most notably, this is done through the sharing economy where services are provided instead of products. For example, someone else provides low cost office space and tools equipment for you to use as your business; or someone else reviews and critiques content for others to read; or someone else cooks meals for pay. All of these services have one thing in common: they earn money passively without requiring too much effort on your part.

Passive incomes can be across-sector (like buying a share in an office space) or within a single industry sector (like being a cook). They come with their own benefits and opportunities, but all require you to give up control over your time. This isn’t necessarily a bad thing unless you feel like you can’t afford to do things because you need to fund your retirement years or you want to start a certain project that requires lots of resources.

In this article we will discuss how some types of passive income are not taxed by the government.

Real world examples of passive income

how is passive income not taxed

Many people get hung up on whether or not investing in an online business is taxable, but that isn’t the right way to think about it.

What most people refer to as “passive income” is really just regular income that you spend your time earning through work. For example, if you are hired to write a book, then writing the book and publishing it is active income. But if someone pays you for writing every day, that’s what we call passive income!

And while some types of income like capital gains or dividends are technically tax-paid before being distributed to you, many experts feel this only applies to the very top tiers of income.

For example, say you make $100,000 per year and receive a net profit distribution check from your employer for 5% of your total compensation. This means that they pay you $5,000 per year more than you paid for everything else (including benefits) and all they ask from you is to send them a little bit of money each month or each quarter.

By the IRS’s own estimates, these quarterly distributions are already taxed at around 40%. So even though this may sound good because you’re paying less taxes now, it’s actually costing you more in the long run by reducing how much money you have available to live on. And remember, living on less money is something almost everyone has experienced at one point in their life.

Treat your business as a small business

As we mentioned before, you can easily create passive income by investing in the stock market or real estate. However, there is an important distinction to make about how those investments are taxed. It’s not like running a normal business where you hire employees and pay payroll taxes.

With the stock market, for example, most people will say that your profits get “capital gains” which are paid at lower rates than ordinary income. But what people don’t realize is that even if their stocks earn very high capital gain returns, they also owe related expenses such as investment fees and tax preparation.

These costs reduce the true profit of the investment and increase their effective expense ratio. For this reason, many wealthy individuals actually have a much higher taxable income than what is reported because they are able to deduct these costs from their overall income.

Capitalize your income

how is passive income not taxed

There is an argument that says investing in assets or activities that produce passive income isn’t necessary smart because you are paying people to do what you could be doing yourself, thus taking profit from your investment. This argument assumes that once you have invested in these things, you will keep spending money on them even if they aren’t producing very much revenue.

This argument ignores two important points: first, most people don’t spend enough to make much difference on their own personal investments; second, there are ways to maximize the return on your investments while still keeping it tax-free.

I read somewhere (can’t remember where) about how we spend our lives trying to get more time to devote to other things, but less time for ourselves. So start giving yourself time to focus on self-care by creating and sustaining passive income strategies.

Take your capital gains yearly

how is passive income not taxed

Another way to avoid paying income tax on passive income is by applying an exception called “net profit loss carryover.” This occurs when you incur significant losses in one year, but still owe money from prior years.

In that case, instead of having to include the net profits from those earlier years as taxable income, we can apply the net profit loss carryover. You may be familiar with this concept if you have ever sold a house or business. When you sell anything, you usually lose money (the cost of sale is included in gross sales).

But after expenses, there is left over revenue that is categorized as net profit. Most people recognize this as cash received during the sale. That extra money is carried forward to future years under the net profit loss carryover rule.

Applying the net profit loss carryover allows you to exclude that amount of money from current year income. For example, say you bought a car for $10,000 two years ago. It now costs $8,000 to buy it back. So you write off the $2,000 loss today as a deduction. But you also retain the old car so you do not get new car benefits like credit cards or insurance because they require ownership of a vehicle.

This makes sense because you will probably keep that type of benefit next year when you purchase another vehicle. By allowing you to exclude the net profit, the IRS gives you permission to skip that income level.

Be familiar with tax laws

how is passive income not taxed

As we have discussed, even if you are not actively working to generate income, you may still be considered an employee or entrepreneur for tax purposes.

If you meet the definition of employer under IRC Section 3121(d), then you must pay employment taxes like payroll taxes and health insurance premiums. You also may face additional penalties for failing to withhold these taxes properly from your employees’ wages.

In addition, entrepreneurs can run into issues when it comes time to file their business returns. They may need to include some extra records in order to prove they ran their business as an LLC instead of being taxed as a sole proprietorship.

It is important to be aware of all of your legal obligations so that you do not get audited or charged improper fees.

Stay updated with tax laws

how is passive income not taxed

The term passive income is typically defined as income that you earn while still spending your time doing something else. For example, if you own a restaurant, this would be considered active income because you are having to work longer to make enough money to survive. If there’s no one in the restaurant, then it is considered passive income since you aren’t actively working, but you're making enough money for yourself so your survival has been secured.

With all of these definitions out of the way, let's talk about how is income isn't taxed when it comes to achieving this goal of having extra cash coming in. There are several strategies and concepts related to achieving this dream of yours. Some people refer to this category as high return investments or self-investing.

One such concept is owning a business. By investing in a business opportunity, you will receive some of the profits the company makes which can then be re-allocated towards more personal expenses. These types of businesses include anything form of marketing, consulting, education, and merchandise. This article will focus mostly on educational opportunities.

A popular type of online education is learning courses via YouTube. Many individuals have made a large amount of money by creating their own YouTube channel content marketable to various audiences. Creating videos is a medium that most people have access to, and using your knowledge to create entertaining content may just help you achieve your dreams of leaving this world better than before.

Create your own business plan

how is passive income not taxed

As we mentioned before, with every form of income, including passive income, you must report it in your tax return. This is not limited to direct reports like wages or distributions from an IRA, but also includes capital gains.

In fact, according to Forbes, “The IRS says anyone getting dividends, interest, retirement benefits or other taxable income should be able to classify that activity as a ‘passive’ pursuit.”

This means that if you have your bank account balance rise by $5,000 per month due to monthly dividend payments, you would need to include that money along with your salary in your taxes.

It is important to note, however, that just because something is taxed does not mean people who engage in such behaviors are dishonest. It is simply how our tax system works.

Know your financial goals

how is passive income not taxed

As we mentioned before, you do not have to exclusively focus on paying off as much debt as passive income. It is important to know when it’s time to shift your investment strategy.

If you want to keep your money for spending or investing in the long term, then consider putting away some of that wealth in the form of regular, recurring monthly payments. This could be through an online service like Amazon Prime, a yearly membership at a fitness center, or even a small business venture that you own.

These types of services cost a few dollars per month, but they can easily add up over time — especially if you are a heavy user. By investing in these services now, you will still get use out of them years down the road, which may give you additional intangible benefits.

For example, say you invested in an annual gym membership back when you were in college. Years later, you decide you would like to get into shape, so you purchase a new memberhips. What happens though? You find yourself never using the facility because you cannot afford the price!

By investing in such a thing early on, you gave yourself a leg-up on staying motivated to work out. Even if you never use the equipment beyond what is included with your current memberships, you will receive indirect benefit from having this habit.

About The Author

Tiara Ogabang
Tiara Joan Ogabang is a talented content writer and marketing expert, currently working for the innovative company With a passion for writing and a keen eye for detail, Tiara has quickly become an integral part of the team, helping to drive engagement and build brand awareness through her creative and engaging content.
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