How Is Passive Income Taxed

The term passive income refers to money that you earn without much effort. You do not need to actively work to make this income, it will just kind of add up for you. Some examples of passive income are if you create a website and sell advertisements or products on it, royalties, dividends, interest payments, and tithing (giving away a significant amount of your earnings) are all examples of passive income.

With the rise in technology, there are many ways to generate passive income these days. Online businesses have become very popular as people are able to access them through their phones and computers anywhere they have internet. By offering services such as web hosting, domain names, and online courses, site owners can earn revenue passively!

Taxation is an important part of earning and achieving financial stability and success. Unfortunately, how we pay our taxes depends mostly on who us individuals belong to- whether it’s a family member, friend group, social circle, or community organization. This article will go into more detail about some common types of tax avoidance strategies and what situations may be illegal. However, before reading any further, please keep in mind that using any type of tax evasion technique is not legal.

This article will also talk about one of the most controversial types of tax evasion: investing in cryptocurrencies. Many people argue that investing in cryptocurrency is not truly equivalent to buying and owning real estate, cars, etc., so it should therefore be taxed at a lower rate.

Capital losses

how are passive income taxed

One of the most common ways to reduce your income tax liability is via capital gains or losses. When you sell an asset, such as a house or car, you can deduct the total cost of the asset from the sale price.

This is called depreciating the asset. You typically have to wait two years before you can take this deduction though.

By doing so, it lowers your effective income tax bracket slightly. For example, if your top tax rate was 25% then owning the home would put you in the higher 24% tax bracket instead of the lower 31%.

Similarly, when you purchase an asset, such as a boat or plane, you can write off the depreciation over time. This also decreases your taxable income.

However, there are some pretty hefty restrictions on how much you can write off per year depending on your annual income.

Net operating loss

how are passive income taxed

A net operating loss (NOL) is when your income exceeds your expenses. Your NOL can be carried forward to future tax years, and it decreases your taxable income. It’s considered passive because it occurs during the year the income comes in and the expense happens at a later time.

A standard way to use your NOL is to deduct it from your regular income tax liability. For example, say you have an ordinary income of $10,000 for the month. You also have a NOL of $2,500 that you carry over. So, your monthly ordinary income tax liability is only $7,500. You would then subtract your NOL from this number to find your net income, which is $1,500 per month or $20,400 per year.

Your yearly income tax burden will drop by more than half due to your NOL.

Passive income

how are passive income taxed

What is passive income? That’s a great question! Technically, it’s when you earn revenue without doing anything to promote or facilitate that revenue. For example, if I hire someone else to create a creative product marketing material for me, that’s considered passive income. They produce the content, I get to enjoy it, and they reap the rewards.

But what most people refer to as “passive income” isn’t actually that passive. In fact, there are several taxes that must be paid on it. And while some of them can be minimized, none of them can be entirely eliminated.

In this article, we’ll go over all the different types of passive income, how much tax they impose, and strategies to minimize those taxes. Before we dive in, let us review some basic concepts about taxation.

Basics of Taxes On average, each country in the world collects around twenty-five percent (or more) of their GDP (Gross Domestic Product) through tax revenues. This percentage fluctuates slightly from year to year, but staying within certain limits will ensure that your savings remain relatively stable. Because of this, it’s important to understand where your money goes once it leaves the source.

Taxes work by taking away your hard earned wealth. It is designed to punish wealthy individuals, because the rich have enough resources to make up for any spending mistakes they make.

Tenants in common

how are passive income taxed

In a tenant-in-common situation, your roommate or roommates are also owners of their apartment. Therefore, they have an obligation to pay property taxes on this shared asset, as well as a responsibility to maintain it.

In addition to these obligations, tenants in common are liable for any damage done to their neighbor’s belongings. For example, if someone else’s cat wreaks havoc in yours, you would be held responsible.

Tenants in common can also face additional tax liabilities depending on how each person uses his or her space.

For instance, if one tenant spends most of his time working from home, he may claim his bedroom as his office and thus exclude it when calculating income. Conversely, if another person works mostly outside the house, she may include the cost of her workspace in her living expenses and therefore not report the same level of income.

S corporation

how are passive income taxed

An additional layer of taxation is imposed when an individual elects to form their business as a limited liability company (LLC) or a service-based organization called a “S” Corporation.

Typically, these types of businesses are set up with another entity that owns the assets of the business; for example, your LLC might be owned by an investment firm. This other party can then manage and pay taxes on the income and losses from the business without impacting you personally.

In order to avoid this second level of taxation, individuals must recognize what is referred to as the “small business safe harbor.” The small business safe harbor applies to certain passive activities.

A passive activity is defined as any trade or business in which the taxpayer does not actively work during the tax year and instead earns profits through the successful marketing of the product or provision of the service.

Certain types of investments such as investing in real estate or owning rental properties fall under the category of being considered active due to the amount of time and effort it takes to own them. In fact, investors are actually required to keep records detailing how much money they spent on maintenance, repairs, and improvements to ensure they meet the one year requirement.

By incorporating your business though, you have eliminated that requirement! As long as your business doesn't do more than $1 million in annual revenue, your personal financial situation is never impacted.

D corporation

how are passive income taxed

A business owner can choose to have their income taxed as personal rather than corporate by starting your business in the form of an S Corporation. This is typically done when the business owner wants limited liability, or they want to limit how much tax they pay due to being married with children or having other investments that can bring in money such as retirement accounts.

However, there are times when using this method of taxation isn’t the best option. For example, if you make very high incomes it may be more beneficial to keep those earnings in the form of individual wages and salaries instead of incorporating.

Another reason to use the individual route over an LLC or C-Corp is because individuals are allowed to deduct certain expenses from gross income, whereas corporations aren’t. These deductions include things like employee benefits, depreciation, etc. So although the company pays taxes, its owners don’t get these deductions so only part of their income is actually sheltered.

There are also some types of dividends and distributions (such as capital gains) that are taxed at lower rates for individuals not for companies. And since most people are still used to thinking about stock market investing in terms of individuals owning shares of companies, it can be confusing as to what kind of income is taxable and what is not.

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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