How Is Passive Income Taxed?

Thanks to the growing prevalence of online investment platforms like Yieldstreet, generating passive income has never been easier than it is today. But as so many everyday consumers and non-accredited investors begin building their portfolios, it's important that they also understand how the IRS categorizes passive income, more specifically how these categorizations will have an impact on their taxes. 

What counts as passive income? 

The IRS defines passive income as "any rental activity OR any business in which the taxpayer does not materially participate." More specifically, this means that an investor must not be "active in the running of [the] business on a continuous and substantial basis" in order for the investment to be considered passive, as determined by the existing criteria for material participation.

How Is Passive Income Taxed?

There are three primary factors to consider when determining how passive income may be taxed: the amount of income generated from sales (capital gains), how long the investments are held (short term vs. long term holdings), and the net income of the investor (personal tax category).

Capital Gains - Any profit taken from the sale of an asset, whether it's a stock, a building, or a piece of artwork, is considered a capital gain and will be taxed by the IRS accordingly. Generally speaking, higher total gains will yield higher tax rates, however, it is important to remember that assets sold at a loss can also be factored in when filing tax information, allowing investors to leverage losses in order to reduce their overall liability. 

Short Term vs. Long Term Holdings - Simply put, short-term holdings are investments held for less than one year, and long-term holdings are investments held for over one year. What makes this distinction so important, however, is that short-term holdings will be taxed the same as an investor's annual income, whereas investments held for longer periods often come with significantly reduced rates.

Personal Tax Categories - Which federal tax bracket an investor falls under will also contribute to the rate at which passive income may be taxed, in addition to the length of the investment. As of 2021, short-term gains are treated and taxed like regular annual income at rates of 10%, 12%, 22%, 24%, 32%, 35%, and 37%. This means that even a single taxpayer eligible for the lowest rate of 10% could end up paying a much higher rate if a short-term investment yields a considerable return. By contrast, only three tax rates can currently be applied to long-term holdings, depending on the annual income of the investor: 0%, 15%, and 20%. This means that if a single taxpayer holds an asset for five years while maintaining an annual income of $39,375 per year or less, the taxpayer would owe 0% in capital gains, regardless of the sale amount. Even taxpayers in the highest bracket can save up to 17% on capital gains taxes simply by opting for a long-term investment strategy. 

Source: Yieldstreet