Passive income, often said to be the key to financial freedom, is income earned with minimal or no direct involvement. Examples include rental properties, dividends from stocks, royalties, and peer-to-peer lending. However, passive income is not entirely free from the clutches of taxation.
This article will walk you through the taxation process for various types of passive income in a step-by-step manner. It is crucial to understand how passive income is taxed to plan your investments and tax liabilities efficiently.
Step 1: Identify the Type of Passive Income
The first step is to identify the type of passive income you’re earning, as the taxation rules may vary depending on the income source. Common types of passive income include:
- Rental income from real estate properties
- Dividends from stocks or mutual funds
- Interest from bonds, CDs, or savings accounts
- Royalties from intellectual property
- Peer-to-peer lending
- Capital gains from the sale of investments
Step 2: Understand the Tax Implications for Each Type
Once you’ve identified the passive income source, you need to understand the specific tax implications associated with it. Here’s a brief overview of how various passive income types are taxed:
- Rental Income: Rental income is taxed as ordinary income, with rates depending on your overall taxable income and filing status. Expenses related to maintaining and managing the property, such as repairs, insurance, and property management fees, can be deducted to lower your tax liability.
- Dividends: Dividends are typically classified as either “qualified” or “non-qualified”. Qualified dividends are taxed at a lower long-term capital gains rate (0%, 15%, or 20%, based on your taxable income), while non-qualified dividends are taxed as ordinary income.
- Interest: Interest income is generally taxed as ordinary income. However, interest from municipal bonds is tax-exempt at the federal level and sometimes at the state and local levels.
- Royalties: Royalty income is also subject to ordinary income tax rates. However, you may be able to claim deductions for expenses related to producing the intellectual property.
- Peer-to-peer Lending: The interest received from peer-to-peer lending platforms is taxed as ordinary income. Additionally, any losses due to borrower defaults can be used to offset other taxable income, subject to certain limitations.
- Capital Gains: Capital gains are profits realized from the sale of investments like stocks, bonds, and real estate. They are classified as either short-term (held for one year or less) or long-term (held for more than one year). Short-term capital gains are taxed as ordinary income, while long-term gains are taxed at more favorable rates (0%, 15%, or 20%, depending on your taxable income).
Step 3: Keep Accurate Records
Maintaining accurate records is essential for calculating and reporting your passive income and deductions accurately. Ensure that you have a reliable system for tracking income, expenses, and asset sales, along with the relevant supporting documents.
Step 4: Report Your Passive Income on Your Tax Return
Passive income must be reported on your tax return. The specific forms and schedules you’ll need to use depend on the type of passive income you’re reporting:
- Rental Income: Report your rental income and expenses on Schedule E (Supplemental Income and Loss) and attach it to your Form 1040 or 1040-SR.
- Dividends and Interest: Report dividends and interest on Schedule B (Interest and Ordinary Dividends) and attach it to your Form 1040 or 1040-SR.
- Royalties: Royalties are also reported on Schedule E, as they are considered supplemental income. List royalties in the appropriate section and attach Schedule E to your Form 1040 or 1040-SR.
- Peer-to-peer Lending: Report interest income from peer-to-peer lending on Schedule B and attach it to your Form 1040 or 1040-SR. If you have losses due to defaults, report them on Schedule D (Capital Gains and Losses).
- Capital Gains: Report your capital gains and losses on Schedule D and attach it to your Form 1040 or 1040-SR. Additionally, complete Form 8949 (Sales and Other Dispositions of Capital Assets) to provide details about your individual transactions.
Step 5: Calculate and Pay Estimated Taxes
If you expect to owe at least $1,000 in taxes on your passive income after subtracting any withholdings and credits, you may need to make estimated tax payments. The IRS requires taxpayers to pay their taxes throughout the year, either through withholding or estimated tax payments.
To avoid penalties, ensure that you pay at least 90% of your current year’s tax liability or 100% of your prior year’s tax liability (110% if your adjusted gross income exceeds $150,000 or $75,000 if married filing separately).
To calculate and pay your estimated taxes:
Use Form 1040-ES (Estimated Tax for Individuals) to estimate your tax liability for the year, including your passive income and any applicable deductions and credits.
Divide your estimated tax liability by four to determine the amount of each quarterly payment.
Make estimated tax payments by the due dates, typically April 15, June 15, September 15, and January 15 of the following year.
Step 6: Consult a Tax Professional
Tax laws and regulations can be complex and may change from year to year. If you’re uncertain about your tax obligations or want to ensure that you’re taking full advantage of deductions and credits, consult with a tax professional. A certified public accountant (CPA) or enrolled agent (EA) can provide personalized guidance and assist you in preparing and filing your tax return.
Understanding how passive income is taxed is crucial for managing your investments and tax liabilities effectively.
By identifying the type of passive income, learning the tax implications, keeping accurate records, reporting your income on your tax return, and making estimated tax payments you can stay in compliance with tax laws and potentially reduce your tax liability.