Smith 
Passive income is often considered one of the best ways to earn money. It’s essentially income that requires little to no effort on your part, freeing you up to do other things or simply enjoy life. Financial planner Jeff Rose is a strong advocate for passive income, and he even wrote about 28 ways to achieve it. However, like any other type of income, passive income is generally subject to income tax. The way it’s taxed can depend on its source and type.
What Makes Passive Income Passive?
Achieving a passive income source often involves a lot of upfront effort. For example, if you sell your business and receive monthly payments from the new owner, that income is passive. However, building the business took years of active work. Another example is earning $10,000 per month from a blog you now spend minimal time managing. The years you spent building the blog required extensive work, making this income more semi-passive than purely passive. The IRS has clear guidelines on passive income, making it crucial to differentiate between truly passive and semi-passive income sources.
9 Examples of Passive Income Sources
True passive income sources, requiring no ongoing effort, include:
- Interest from investments like bonds and certificates of deposit.
- Dividends or capital gains from stock investments.
- Rental income and long-term capital gains from direct real estate investments.
- Real estate crowdfunding income where you have limited liability and minimal involvement.
Semi-passive income sources, which require minimal effort, include:
- Running a business that needs little involvement.
- Renting out part of your home.
- Selling products through affiliate marketing.
- Creating and selling digital products like e-books and courses.
- Trading digital assets like websites and domain names.
Even semi-passive ventures need some effort, but this minimal participation is key to their success.
Passive Income for Income Tax Purposes
The IRS has precise guidelines on what counts as a passive income activity, focusing on material participation. This involves the amount of activity you put into generating the income. Here are some IRS criteria for material participation:
- More than 500 hours of activity in a year.
- Participation that’s substantial compared to others involved.
- More than 100 hours and at least as much as any other individual.
- Participation in all significant activities for over 500 hours annually.
- Five years of participation over the last 10 years.
- Personal service activities for any three prior years.
- Regular, continuous, and substantial participation based on all facts.
If these guidelines seem confusing, it’s best to consult a tax professional.
Special Considerations for Passive Real Estate Income
Real estate investments can be tricky. Unless you use a management company, real estate investing usually involves some effort. However, rental real estate is generally considered passive for tax purposes. It offers several tax benefits, such as the ability to write off expenses, claim depreciation, enjoy lower long-term capital gains tax rates, and use the Qualified Business Income (QBI) deduction.
Reporting Passive Income on Your Income Tax Return
Just like any other income, passive income must be reported on your tax return. Despite certain advantages, most passive income is taxed as ordinary income. For example, rental income is reported on IRS Schedule E. Income from investments like dividends or capital gains is issued on forms like 1099-INT, 1099-DIV, and 1099-B. Income from entities like partnerships and S corporations is issued on Form K-1. If reporting passive income seems complicated, consider using tax software or consulting a tax professional.
How Is Passive Income Taxed?
Net income from passive investments is usually taxed as ordinary income. But long-term capital gains (from assets held for over a year) enjoy lower tax rates compared to short-term gains (held for a year or less). For 2024, long-term capital gain rates are:
- 0% for incomes up to $47,025 (single) or $94,050 (married).
- 15% for incomes between $47,025 and $518,900 (single) or $94,050 and $583,750 (married).
- 20% for incomes above those limits.
Passive Income Limitations
Generally, passive losses can only offset passive income. For instance, a $6,000 loss can offset a $10,000 gain, resulting in $4,000 net passive income. If you have a net loss, it can’t offset non-passive income but can be carried forward to future years. The IRS offers a special $25,000 allowance for rental real estate losses against non-passive income, phased out for incomes above $100,000.
At Risk Limits
The IRS limits deductible losses to your investment in a passive activity. For example, if you invest $10,000 and incur a $15,000 loss, only $10,000 is deductible.
Bottom Line on Passive Income Taxation
Passive income is incredibly beneficial, allowing you to earn while engaged in other activities. It comes with generous tax breaks, especially for long-term capital gains and small investors with incomes below $150,000. However, these benefits add complexity to tax reporting, making quality tax software or professional advice essential.
