Passive Income: How is Passive Income Taxed?

Passive income tax

First, what is passive income? Passive income, or unearned income, as the IRS calls it, is defined as income from a trade or business activity in which a taxpayer did not, or currently does not, materially participate, and income from all real estate activities, regardless of their participation (except rental activities for those who qualify as real estate professionals).

Passive income vs. active income tax

There are three main categories of income: active income, passive income, and portfolio income. We’ll be focusing more on active and passive income in this article.

Passive or unearned income is the other side of the “active or earned income” coin, which is income you receive from a job or business venture that requires active participation. As with active income, passive income is taxable.

Generally, passive income is the result of your having worked on something upfront that then reaps rewards for months or years afterward. While you may have done work to get these ventures off the ground, they now generally pay out automatically without you having to do anything.

Passive income includes earnings derived from a rental property, a limited partnership, or other business, in which a person is not actively involved.

It can also be a creative project you worked on and now receive royalties from. You can always ask your Tax Professional about any income streams you may have, and how they’d be taxed per IRS guidelines.

How is passive income taxed?

Passive income is often taxed at the same rate as salaries received from a job, but you’ll want to work with a Tax Pro to get a full view into your entire financial picture. As with active income, it’s possible to use deductions to lessen tax liability. We will go into some of the deductions available below. Typically, passive income is subject to your usual marginal tax rate, which is based on your tax bracket.

It’s important to note that the IRS has standards of material participation to differentiate between active income and passive income. Your Tax Pro can go into these more in-depth to make sure that you’re reporting the correct type of income.

These are some key examples of what the IRS calls “material participation.” At this point, the IRS would consider it “active income,” and tax accordingly:

• If you’ve dedicated more than 500 hours to a business or activity from which you’re gaining income.
• If your participation in an activity has been “substantially all” of the participation for that tax year.
• If you’ve participated up to 100 hours, and that is at least as much as any other person involved in the business.

Types of passive income

There are numerous types of passive income, especially in the age of social media and the internet. Below are just a few examples:

• Rental income: This is one of the most common types of passive income. Renting out a garage, room, or a house or apartment. This can be a short-term or longer-term arrangement. This may also include renting out part of your house for other people to use for storage.
• S corp. Owning shares in an S-corporation due to an investment in the business is generally passive income. Receiving royalties each time your book is sold after the initial sales.

There are many more examples. If you are thinking of starting to earn passive income, talk to your Tax Pro about making sure that you’re reporting the income accurately.

Passive income special allowance for rental property

Just like with your regular income, you may be able to take deductions to reduce the taxes you pay on your passive income. For example, there is a special allowance deduction for rental real estate activities. If you actively participated in a passive rental real estate activity, you may be able to deduct up to $25,000 of loss from the activity from your nonpassive income. Nonpassive income is money you earn from a job or self-employment. This special allowance is an exception to the general rule disallowing losses more than income from passive activities.

The special allowance isn’t available if you were married, are filing a separate return for the year, and lived with your spouse at any time during the year.

Your Tax Pro can help you to see if you’d qualify for this, or any other deductions. Because passive income can take on many forms and is complicated, work with your Tax Pro on other deductions for which you may qualify.

Tax tips for passive income

As mentioned, passive income can make filing your taxes more complicated. There are some good rules of thumb to follow when you have passive income.

1. You should always keep all pertinent documents and ensure that you have all your income statements and the associated expenses for your Tax Pro to work with.
2. Grouping activities can help make the process a little bit easier. For example, the IRS allows multiple trade, business, or rental activities to be grouped into a single activity if they form “an appropriate economic unit.” An appropriate economic unit can be based on a variety of factors, including:

• The similarities and differences in the types of trades or businesses;
• The extent of common control;
• The extent of common ownership;
• The geographical location; and
• The interdependencies between or among activities.

Grouping activities can have a lot of upside. As always, you’d want to work closely with a Tax Pro and make sure that these are grouped accurately.

How to report passive income on your tax return

You’ll want to work with a Jackson Hewitt Tax Pro on reporting losses and credits from passive income. But at a high level, you’d want to attach the forms below, depending on your situation, to your Form 1040, U.S. Individual Tax Return, or Form 1040-SR, U.S. Individual Tax Return for Seniors.

Start with Schedule E, then use Form 8582, Passive Activity Loss Limitations, to summarize income and losses from passive activities, and to compute the deductible losses and any non-deductible losses to be carried forward to future years.

You’d also want to be familiar with Form 8582-CR, Passive Activity Credit Limitations to summarize the credits from passive activities and to calculate the allowed passive activity credit. You may also use Form 8582-CR to make an election to increase the basis of credit property when you dispose of the property.

Questions about passive income?

Having some passive income in addition to your earned income can be a good idea. We gave a broad overview above of the ins and outs of passive income, but there is a lot more to cover and specific questions you may have in regard to your specific situation. Find a Jackson Hewitt Tax Pro near you today to find out more.

About the Author

Mark Steber is Senior Vice President and Chief Tax Information Officer for Jackson Hewitt. With over 30 years of experience, he oversees tax service delivery, quality assurance and tax law adherence. Mark is Jackson Hewitt’s national spokesperson and liaison to the Internal Revenue Service and other government authorities. He is a Certified Public Accountant (CPA), holds registrations in Alabama and Georgia, and is an expert on consumer income taxes including electronic tax and tax data protection.

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