What is passive income? And How is passive income taxed in 2021?

Passive income is what one earns without active participation in an activity. It could be income from various sources like the,

  • Rental properties
  • Limited partnership
  • Portfolio incomes like the interests on deposits and dividends among others.

Thus one can earn passive income without having active participation in the activities. However, the most common question is about taxes. Do many people ask if passive income taxable? if yes how is passive income taxed in 2021?

Features of Passive Income 

Can Passive Income Be Taxed? - Features of Passive Income

The most used sources for generating passive income are-

All these sources have their pros and cons and risks associated. Passive income is the flow of money at regular intervals without the requirement of efforts by a person. One can earn passive income from profits earned on real estate properties or other business-related activities or any other way where the person can seat back relaxed without putting in any effort. Since most incomes are taxable it will be necessary to learn what attracts passive income tax for the earner. 

How Passive Income is Generated

To learn about tax liabilities associated with the passive income it is essential to understand how passive income is generated. Simply speaking it is the generation of extra income without adding to your workload. 

You can earn money thus even when you are sleeping because no activities are required and income generation is automatic. The only requirement for you is to know and work upon passive income tax liabilities. Earning passive income is like putting a vehicle on auto-pilot and does not involve an investment of time, effort, and money like most other ways of income generation.

Passive Income Activities according to IRS

IRS - Can Passive Income Be Taxed?

Internal Revenue Service (IRS) regulates all types of taxes including those related to passive income. According to their 925th publication, there are two types of activities to earn passive income. These are –

  1. Business and trade activities where you do not participate materially but earn a regular income; and
  2. Rental activities whether you participate in the activity materially or not. 

Some of the common ways of generating passive income are dividend stocks, currency exchange trade, investing in bonds and securities, renting out properties, and high-yielding savings paying interests. You can also be a silent partner in an enterprise earning passive income. 

Big Question: How is passive income taxed?

The question - Can Passive Income Be Taxed?

The big question for you will be whether the passive income can bring up additional tax liabilities. The answer to this question is simple. Like any other source, passive income is also taxable. 

  • When you sell a property earning passive income for you the provisions relating to passive income tax becomes operative; 
  • Determination of tax payable will depend on several factors that include the source type and time spent by you on the property; 
  • Income from rental properties will be taxed differently; and
  • As there are multiple sources of passive income it will be good consulting an expert in taxation laws to guide you. 

Consulting Professional Tax Accountant

While pursuing any passive income generating activity also a prudent move will be consulting an expert because there could be avoidable pitfalls in the process. In addition; the professional tax accountant can advise you on the process of avoiding tax penalties on passive income carrying out the operation legally. Such a professional accountant will not only help record maintenance as well as share insights on passive income tax and tell you how to minimize the tax liabilities. It will make your tax return filing easier. 

Passive Income Tax Calculation

When you prepare your tax returns you have to include passive income in them. However, the calculation of the tax amount will depend on several factors. Major factors influencing the determination of passive income tax are as follows. 

  • Type of passive income you are getting; 
  • The type of income sources;
  • Amount of time you spend on the activity; 
  • Whether the source is trade and business activities or rental properties; 
  • Amount of passive income generated; and
  • It can vary from person to person.

In addition to the above; there may be federal, state-based, or local regulations for the determination of the tax quantum that you and your tax accountant have to conform to. 

The necessity of Understanding Passive Income Tax Liabilities

When you are deciding to pursue some activities that will generate passive income adding to your active income it will be necessary for you to learn about the associated tax liabilities. It will help you make an informed decision on the choice of following the best method of generating passive income without attracting big tax liabilities. 

For example; using cryptocurrency-based trading has become a popular way of creating extra income in the modern digital world. When you buy a bitcoin for $500 and resale it when the value has increased to $700 then you generate passive income amounting to $200 and it is taxable like the regular income. On the other hand, if you traded it for $400 then you can use the loss of $100 for tax deductions. 

True and Complete Declaration for Passive Income Tax 

Instead of trying unfair methods to avoid the imposition of taxes, it is always preferable making a complete and honest declaration of the passive income you are making from any source. 

The reason is that timely submission of a complete return will enable you to avoid penalties resulting from detection by IRS or other authorities of undeclared passive income. 

That is also why you and your tax accountant should maintain records documenting each transaction generating passive income with dates to facilitate the perfect statement of all your taxable income including the taxable passive income. The exercise will help you to be in readiness when the time for payment of tax finally arrives. 

The bottom line of all these is that you can use passive income not only as an additional source of money but also to substitute your salaried job to work from home. It is one of the best and safest methods of earning in the development in the market with the outbreak of the Covid19 pandemic and a world heading to Covid26 outbreak. 

Many people have lost their jobs and for them, passive income has now become the main source of livelihood. While passive income can be very helpful in such a situation you should also take care of all issues relating to passive income tax to enjoy legitimate and hassle-free use of such income. If you need any help feel free to reach us for a consultation. – Reza Abbaszadeh