How Passive Income Tax Rates Are Calculated

Passive Income Tax

Establishing passive income streams is a wise move, especially for retirement planning. Also sometimes referred to as “mailbox money,” passive income is that which is earned without physical effort on the part of the recipient. Passive income may be derived from investments with platforms like Yieldstreet that generate interest, dividends, capital gains or rental income. 

Passive vs. Active Income 

Passive income is earned when a tenant pays rent, an investment earns dividends or an investment appreciates in value and is sold at a profit. Active income is usually acquired in the form of fees, salaries or wages. Anyone who has gone to work and received pay for the effort — or performed a service and was paid a fee— has earned active income. 

The funds generated are usually subject to taxation in each of these instances. Tax rates on both active and passive income will vary, depending upon the recipient’s tax bracket and the way the income is classified. With that in mind, here is some information on how passive income tax rates are calculated. 

Types of Passive Income 

The primary sources of passive income are self-charged interest, rental income and business investments. 

Self-charged interest is generated when a person lends funds to a business they own and repays themself with interest on the loan. The IRS considers this passive activity gross income when the loan proceeds are used in a passive activity. 

Rental income is also considered passive income, except when the recipient is a qualified real estate professional who directly participates in the management of the property. Funds earned will be considered active income in that instance. 

Business investment income is considered passive when the person receiving the funds is not directly involved in the operation of the business. The exact rules governing this are outlined in IRS Publication 925

How is Passive Income Taxed? 

While passive and active incomes are largely taxed in the same fashion, passive income derived from long-term capital gains or qualified dividends is treated differently. An investor’s ordinary income tax rate is applied to short-term capital gains while long term gains and qualified dividends are taxed at 0%, 15% or 20% — based upon the investor’s annual taxable income and filing status. 

The profits derived from an asset held longer than a year are considered long-term gains. Those earned from investments of less than a year are considered short-term. Tax savings can amount to as much as 50% of what is applied to ordinary income with long-term capital gains and qualified dividend income for people in the top tax brackets. 

Passive income earned from municipal bonds is usually considered to be tax-free, as far as the IRS is concerned. However, state taxes may be applied to those interest payments in some cases. A good way to determine exactly how the income from an investment will be taxed is to consult an online excess net passive income tax calculator. 

Source: Yieldstreet