This is our third article that we are doing on "How Is My Income Taxed?". Understanding how different types of income are taxed can be confusing and it is something we see pop up in our Free Facebook Group and Tax Minimization Program all the time.

If you haven't checked out our first article, What Is Ordinary Income Tax vs Capital Gain Tax?, check it out now!

There are three main types of income that we want to focus on:

• Earned Income
• Passive Income
• Portfolio and Non-Taxable Income

Today we are going to be focused on passive income. 

What Is Passive Income?

Per the IRS, passive activities include trade or business activities in which you don't materially participate. You materially participate in an activity if you're involved in the operation of the activity on a regular, continuous, and substantial basis. In general, rental activities, including rental real estate activities, are also passive activities even if you do materially participate. However, rental real estate activities in which you materially participate aren't passive activities if you qualify as a real estate professional.

Basically passive income is activities that would continue to generate income if you decided to simply sit on a beach and do nothing. Or in my dream scenario, golf all all day every day and do no work.

Think of things like rental properties or businesses where you do not materially participate in the operations of.

How Is Passive Income Taxed?

Passive income is not subject to FICA or self employment taxes but is still subject to ordinary income taxes. As we discussed in our article, What Is Ordinary Income Tax vs Capital Gain Tax?, this us just your normal income tax using the tax brackets (10%, 12%, 22%, 24%, 32%, 35%, and 37%).

If you sell your interest in a passive activity (ex: sell a rental property) you will be subject to a capital gain or loss.

For those with significant income you may also be subject to the net investment income tax (NIIT) which would be an additional 3.8%.

What Is The Good Thing About Passive Income?

Lets start with the obvious one, you make money without doing any significant work. What gets better than that?

Second, the money you make from it you avoid FICA and self employment taxes on.

Third, and this is one that we will dig even deeper into in our rental property series, but if you look at real estate specifically you typically will have heavy depreciation in the early years so you may still be cash flowing but because of depreciation it will offset that income and thus you will not have to pay taxes on the money you are making on it.

Fourth, as with self employed and business income you can also take advantage of the tax code and take deductions (write-offs) against your income that will help reduce the taxable amount of it.

One thing to note is that often times earned income can eventually turn into passive income. Lets say you are a professional and you are building out an online course. During the development and initial growing of that course it very likely will be earned income because you are heavily involved and actively participating. However you may eventually get to a point where it runs without you, based on both the content produced and the team around you, which then allows you to step away from the business. At that time you may have earned income that turns into passive income.

Finally, passive losses can offset other passive income. Lets imagine you have a new rental property that has heavy depreciation in year 1 but you also have also have an older rental property that is fully depreciated and is simply earning passive income. You can utilize your passive losses from the heavy year 1 depreciation from the new rental property to offset your passive income from your older rental property.

We will be doing a future series on rental activity and how that all plays into it.

What Are The Passive Activity Loss Rules?

The biggest downfall to passive activity is this idea of passive activity loss rules. As we talked about above, often times passive activities can produce large losses in their early years which could be used to offset other income.

However, passive losses can only offset other passive income. You cannot use a passive loss to offset earned income, capital gains (unless from a passive activity, aka rental property sale), or portfolio income. 

Essentially, if you have a rental property (passive) and you have a loss in it due to high depreciation, you can only offset that loss against other passive income (rental activity or businesses you do not actively participate in) but you cannot use that loss to offset earned income (W2) or non-passive capital gains. This can be frustrating for many. 

With that being said, there are some exceptions and work arounds to this that we will be discussing when we do our real estate series coming up soon.

Passive Income - Summary

• Passive income is taxed at ordinary income tax rates (typical marginal tax rates).
• Passive income is not subject to FICA or self employment taxes.
• Passive activity is income sources in which you do not actively participate in.
• If you sell your interest in a passive activity this will create a capital gain or loss.
• Passive activity includes most real estate unless you are a real estate professional.
• Passive losses can offset other passive income. However passive losses can not offset earned income, capital gains (unless from a passive activity), or portfolio income.
• An activity could potentially start out as earned income but move into passive income.

Be sure to check out other articles in our "how is my income taxed" series.