Is Passive Income Taxed?

  • 4 minute read

Passive income refers to income earned through activities that require little to no active participation, such as rental income or investment income. Many people are attracted to the idea of passive income because it can provide a source of income without requiring ongoing work or effort. However, one important question to consider is whether passive income is taxed.

The short answer is yes, passive income is typically subject to taxation. In the United States, passive income is generally taxed at the same rates as other types of income, such as wages or salary. This means that if you earn passive income, you will need to report it on your tax return and pay any applicable taxes.

Which forms of passive income are taxed?

In general, most forms of passive income are subject to taxation. Here are some examples of passive income sources that are typically taxed:

  • Rental income – If you own rental property, the income you earn from renting out the property is considered passive income, even though you may have some obligations to maintain the property. 
  • Investment income – Passive income from investments, including dividends, interest, and capital gains, is typically considered investment income and is subject to taxation.
  • Royalties – When you earn money from the use of your intellectual property, such as a book or a song, in the form of royalties, this income is categorized as passive income, and you will need to pay taxes on it. 
  • Peer-to-peer lending – If you earn income from lending money through a peer-to-peer lending platform, the income is considered passive and is taxed.
  • Affiliate marketing – Affiliate marketing is a revenue-sharing model where individuals promote and sell products or services of other companies and receive a commission on successful sales. Income earned through affiliate marketing is classified as passive income and is subject to taxation under current tax law. 

It’s worth noting that the tax treatment of passive income sources can vary depending on factors such as the specific type of income and the taxpayer’s individual tax situation. Additionally, there may be deductions and tax incentives available that can help reduce the amount of tax owed on passive income.

History of passive income taxation

The history of passive income being taxed dates back to the introduction of the federal income tax in the United States in 1913. Initially, the tax only applied to high-income individuals and corporations, but over time, the tax has been expanded to include a wider range of income sources and earners.

Today, the tax code provides a variety of tax incentives and deductions that can help reduce the amount of tax owed on passive income. For example, if you own rental property, you can deduct expenses such as property taxes, mortgage interest, and repairs from your rental income.

How to manage passive income taxation?

Managing passive income taxation involves taking proactive steps to minimize your tax liability and ensure that you are meeting your tax obligations. We’ve compiled some useful tips to help you handle passive income taxation:

Keep accurate records

Proper record-keeping is critical for anyone earning passive income. This means keeping track of all income and expenses related to your passive income streams. By documenting receipts, invoices, and other relevant information, you can claim eligible deductions and lower your tax burden.

Take advantage of deductions and tax incentives

To reduce your tax liability, take advantage of available deductions and tax incentives. If you own rental property, you can deduct expenses like property taxes, mortgage interest, repairs, and even travel expenses related to your rental activities. For example, if you travel to your rental property to collect rent or handle repairs, you can deduct your travel expenses.

Consider forming a business entity

If you earn passive income through various sources, it might be worth considering forming a business entity, like a limited liability company (LLC) or S corporation. Such entities come with tax benefits that can reduce your tax liability and increase your take-home earnings. Here are some examples in which a business entity can help your tax situation:

  • Rental property ownership – By forming an LLC, you can deduct rental property expenses, such as maintenance costs, property taxes, and mortgage interest, from your rental income. This helps reduce your tax burden and leaves you with more money in your pocket.
  • Affiliate marketing – By forming an S corporation, you can deduct expenses such as advertising costs, web hosting, and affiliate commissions from your earnings. This lowers your taxable income and can lead to significant tax savings.

Pay estimated taxes

Earning passive income can trigger an obligation to pay estimated taxes to the IRS. You may need to make quarterly payments based on the expected annual amount of passive income. Failure to do so can lead to costly penalties and interest charges.

To avoid these charges, it is crucial to make timely and accurate estimated tax payments. For instance, if you have rental properties and anticipate receiving $10,000 in annual rental income, you may be required to make quarterly estimated tax payments of $625 to the IRS. 

Collaborating with a tax expert can help ensure that your estimated tax payments are correct and made on time, saving you from potential legal and financial problems down the line.

Stay informed on tax changes

Staying up-to-date with tax laws and regulations is crucial for anyone earning passive income. Changes in tax policies can impact the amount of taxes you owe and the deductions you can claim, so it’s essential to stay informed and work with a tax professional if necessary.

For example, in 2020, the Coronavirus Aid, Relief, and Economic Security (CARES) Act provided certain tax benefits for individuals with passive income. These benefits included changes to the rules for net operating losses and limitations on business interest expenses. Without keeping up-to-date on these changes, individuals earning passive income may miss out on valuable tax savings.

Stay informed on tax developments through resources such as the IRS website or financial news outlets.

Taxes Aren’t Going Anywhere

No one enjoys paying taxes, but they aren’t going anywhere, so it’s best to get a good handle on your tax liability. Looking to the future, it’s difficult to predict what changes may be made to the taxation of passive income. However, given the ongoing debates around tax policy and income inequality, it’s possible that changes may be made to the tax code in the coming years.

Some policymakers have proposed increasing taxes on passive income as a way to address income inequality and provide more revenue for social programs. Others have suggested reducing or eliminating taxes on passive income as a way to incentivize investment in smaller business ventures and promote economic growth.

Ultimately, the future of passive income taxation will depend on economic conditions, political priorities, and public opinion. However, it’s safe to say that passive income will likely continue to be subject to taxation in some form or another.