How Is Passive Income Taxed

As we know, passive income is income that keeps flowing to you, without your intervention. This could be through investments or regular sources of revenue like working in an office job with paychecks every two weeks.

Most people understand that active investing means doing all of the work to pick stocks and manage your portfolio, but there’s another kind of investing that many people don’t realize is actually considered to be more passive.

This type of investing doesn’t require you to do any research or spend any money to get started. By using certain strategies, you can earn enough passively to meet your financial goals.

Passive income comes from things such as dividends, asset growth (interest), royalties, and tax refunds. Some people refer to these types of earnings as “peek-behind-the-curtain” revenues because they feel that it’s not what anyone really wants to talk about when promoting their business idea.

However, this hidden source of income can add up to big bucks over time. And while most individuals will never have access to these types of revenues, some lucky few will.

Short-term capital gains

how is passive income taxed

The term short-term capital gain refers to when you sell an asset (like a car) that you have owned for less than one year. When you sell such an asset, you must determine whether or not it is classified as a long-term or a short-term capital loss.

If the sale of the asset is due to poor performance or lack of use, then it is considered a deductible business expense under Section 179 of the IRS Code. This means that you can write off part of the cost of the asset in your income tax return!

However, if the reason for selling the asset is because it no longer matches the purpose for which it was purchased, then it is not eligible for this deduction.

In these cases, the sold item will be treated like any other asset, and the difference between what you got and its original price will be called a capital gain or profit.

This is where things get tricky. Because the item being sold has decreased in value over time, the amount of money made from the sale of the item is also decreasing.

Long-term capital gains

how is passive income taxed

This is what most people refer to when they talk about “the rich getting richer” because it applies only to stocks. It refers to how income from the sale of your house, or car, or business is treated in tax law.

Under long term capital gain taxation, the seller doesn't have to include the profit from the sale in their taxable income unless the item was held for more than one year.

This can be confusing since most people think that if you sell an expensive stock, then you must pay higher taxes. But this isn't always the case!

That's why it's important to know which types of income are taxed differently. By being aware of these, you'll be able to stay out of trouble with the IRS.

Limit on how much you can earn and pay

As mentioned before, one of the biggest ways that passive income is taxed is by how much money an individual makes. This is referred to as your “earned” or “salary-based income.”

The amount that equals the maximum annual salary for a given year is called your "threshold" or "cap". Once you reach this threshold, any additional income becomes taxable at a higher rate.

This means that if you make $5,000 per month (or $60,000 per year), then you have already reached your cap and are taxed at a higher marginal tax bracket!

Any excess income over this is also taxed at a higher rate. For example, if you make $2,500 per month ($30,000 per year) beyond your threshold, then half of these extra earnings get taxed at a 40% marginal tax rate! The other half gets taxed in a lower 20% bracket.

Self-employment tax

how is passive income taxed

There is an additional cost for self-employed individuals to start or run their business that most people are not aware of – there is what’s called “self- employment tax.” This tax applies to every income source of yours as an entrepreneur, including profits, capital gains, and dividends.

Self-employment taxes apply when you earn more than $100,000 in total earnings (net wages from your job plus other income) during the year. What this means is that if your monthly net profit is greater than $1,500, then you will be charged self-employment tax on it.

This can easily add up since many self-employed individuals have large net incomes due to the nature of their businesses. It also doesn’t matter whether you make a small net profit per month or a very big one, you still may be taxed depending on how much money you made overall.

There is no standard rate of self-employment tax like we have with normal income taxes; instead, it depends on two things: Your marginal rate and your annual gross income. The first number refers to how much tax you pay on each extra dollar of income, and the second refers to how much money you make in general.

For example, someone who makes $50,000 per year and has a marginal rate of 25% would get charged $2,500 in self-employment tax on any extra income they make over $12,500.

Capital loss

how is passive income taxed

A capital loss is when you sell an asset for less than its cost. For example, if you buy a car for $5,000 then lose it in a crash, your net profit is $2,500 (the difference between the sale price and the cost).

You can use this money to reduce your income tax bill. The amount of the deduction depends on what year the loss happened and whether or not you are still paying off debt at that time.

But remember, if you make more than $52,200 per year as a single person or $78,600 as a couple, then any losses will be taxed normally against your income.

After all, these are considered investments. Most people consider cars an investment. So, investing in a new car could result in a large tax refund. But buying a used car – even one with good mileage- probably makes sense too.

About The Author

Tiara Ogabang
Tiara Joan Ogabang is a talented content writer and marketing expert, currently working for the innovative company juice.ai. 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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