If you’ve been fortunate enough to enjoy passive income from your investments, it’s crucial to understand how passive income is taxed. Understanding how the IRS classifies passive income versus non-passive income could make or break your potential return on investment. The more you know, the more prepared you’ll be for tax season, So let’s start with the basics.
What is Passive Activity?
The IRS describes passive activity as “any rental activity OR any business in which the taxpayer does not materially participate.”
As outlined by the IRS, material participation is defined as regular, continuous, and substantial involvement in a business’s activities.
The standards for material participation include:
- 500+ hours toward a business or activity from which you are profiting
- If participation has been “substantially all” of the participation for that tax year
- Up to 100 hours of participation and at least as much as any other person involved in the activity
- Material participation in at least five of the past 10 tax years
- For personal services businesses, material participation in three previous tax years at any time
According to the IRS, there are two categories of passive activity. The first type is rentals, including equipment and real estate, and the second type is businesses, in which the individual does not materially participate on a regular, continuous, and substantial basis.
The following are considered passive activities:
- Equipment leasing
- Rental real estate (some exceptions apply)
- Sole proprietorship or farm where the individual does not materially participate
- Limited partnerships
- Partnerships, S-Corporations, and LLCs where the individual does not materially participate
How Passive Income is Taxed
There are different types of passive income, from capital gains and dividends to income earned on interest. Is passive income taxable? The short answer is yes. Tax rates on each type of passive income will vary based on how long your investments are held, the amount of profit earned, and/or net income. Let’s go over capital gains to understand how passive income is taxed.
What Are Capital Gains?
The profit an individual earns from the sale of a property or an investment is called a capital gain.
For example, if an investor sells a stock and makes a profit on that sale, this is considered a capital gain. There are many assets, including personal assets and investments, that fall under capital assets. These include your car, home, investments, rental properties, etc.
Investors can also experience capital losses, which occur when the sale price of an asset is less than its original purchase price. Basically, if you lose money on any investment, it will be reported on your taxes as a capital loss and may be deducted from capital gains made from another investment.
Two Tax Categories for Capital Gains
Capital gains fall into two categories: short–term and long–term. Investments that qualify as short-term are usually held for a year or less and are taxed at your regular income tax rate. Long-term investments are typically held for longer than a year and are taxed at a lower rate than ordinary income tax.
Next, let’s review the new tax brackets for both short-term and long-term passive income.
Passive Income Tax Rate for 2020
At the end of 2017, President Trump signed the Tax Cuts and Jobs Act. These 2018 tax cuts lower taxes for individuals and businesses throughout the United States.
The new tax plan’s three big advantages include lower tax rates, several additional tax deductions, and a lower corporate tax rate.
There are four filing categories for taxpayers: single, married and filing jointly, head of household, and married and filing separately. How much you pay in taxes is based on income, which we will discuss in the following sections.
Short-Term Passive Income Tax Rates
As mentioned previously, short-term gains apply to assets held for a year or less and are taxed as ordinary income. In other words, short-term capital gains are taxed at the same rate as your income tax. The current tax rates for short-term gains are as follows: 10%, 12%, 22%, 24%, 32%, 35% and 37%.
For example, let’s say you buy and sell a stock that produces $9,000 in profits over the course of a year or less. If you’re filing as a single taxpayer, you would be placed into the lowest tax bracket or rate of 10 percent, owing $900 in short-term capital gains tax.
Whereas the highest tax bracket or rate of 37 percent applies to capital gains above $510,301, resulting in $188,811 of taxes owed as a single-filer.
It’s easy to see that holding investments for a short period will inevitably result in much higher tax rates.
Long-Term Passive Income Tax Rates
Long-term capital gains (assets held for more than one year) are taxed at three rates: 0%, 15% and 20%, based on your income bracket.
For example, a person filing as single and earning less than $39,375 would owe 0 percent on any long-term capital gains. If an individual (single-filer) makes between $39,376 and $434,550 in yearly income and chooses to sell a long-term investment or asset, a 15% tax rate would be applied to any profits earned. Married and filing jointly, while earning below $78,750 in yearly income, are not taxed on capital gains on investments.
Clearly, there are substantial tax advantages to buying and holding investments long-term rather than short-term.
How is Passive Real Estate Income Taxed?
With lower tax rates, it’s now even more beneficial for individuals to invest in real estate and high-yield rental properties.
With buy-and-hold real estate, the qualified business income deduction is now a 20 percent deduction on taxable income. This 20 percent deduction now allows investors to deduct a portion of their real estate investment properties, which could result in a higher ROI.
Next, let’s review four ways real estate investors can benefit from the new tax cuts act.
- Pass-through Deduction to Qualify for the 20% Deduction (New 199A). With the new 20 percent deduction on pass-through income, LLCs, sole proprietors, and S-corporations can now pass taxes onto the owner. Real estate investors with secured investments in LLCs will enjoy significant savings via this new pass-through rule.
- 20% Deduction on Taxable Income. To qualify for a 20 percent deduction on taxable income, a single individual must make less than $157,500 per year, or when filing jointly/married, income below $315,000 per year. There are ways to keep your income below a certain amount and qualify for these major tax cuts including, contributing to your retirement accounts, transfer income through to a C Corporation or donate to a charity.
- 100% Bonus Depreciation. If something depreciates in less than 20 years, this expense can be completely written off in the first year. For instance, the cost of small home improvement projects on your investment property can be deducted from your yearly taxes.
- Use Section 121 and 1031 Exchange to Avoid Real Estate Tax. Investors selling a profitable residence can take advantage of the 1031 Exchange and avoid paying some of the taxes on capital gains. If the owner has lived in the home for 2 out of 5 years, they qualify for Section 21 and only pay a portion of taxes on profit upon selling. Then, use the 1031 Exchange to buy a rental property with some of the profit earned and avoid paying taxes on the sale of the residence.
Work With a Professional
Now that we’ve answered the questions, what is passive activity, how is passive income taxed, and how does the new passive income tax rate impact your investments? The next step is to consult your expert advisors. Ask your investment consultant and tax advisor how to qualify for tax breaks. By doing so, investors will save money, increase ROI, and deduct qualified expenses from their next tax return.
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