If you've managed to create one or more passive income streams over the past year, good for you! Adding more ways to get cash into your bank account gives you more ammunition to pursue your financial goals as well as a safety blanket in case something affects your primary means of paying the bills.
But adding passive income means adding, well, income — and where income is involved, you can be sure of one thing: The taxman cometh.
That's not a bad thing. After all, if you're paying more in taxes, it's almost always the result of you making more money. Still, knowing the rules is important. Different kinds of passive income come with different tax statuses, and understanding them is key to making sure that you don't miss out on important deductions or fail to report all of your income, which can trigger audits and penalties.
Note: Everyone's tax situation is unique, and some are more complicated than others. If you've added a passive income stream in the past year or plan to add one this year, it's wise to talk with a tax professional about best strategies for filing your return.
Here's a general overview of how four of the most common forms of passive income are taxed.
One of the cheapest, easiest, and most common ways to earn passive income is to park your money in a high-yield savings account.
If you earn $10 or more in interest from a high-yield savings account, that money is taxed at your marginal income tax rate after the appropriate deductions have been applied. Your bank will likely send you a 1099-INT form to fill out early in the year if the $10 threshold has been reached.
While your contributions to any such account aren't taxed, any income you earn from the account is, including any cash bonus you may have received for signing up for the account, which is treated as interest for tax purposes.
What you'll pay in tax on investment income depends on what you hold and the type of account you hold it in. You'll owe no tax this year if you hold income-producing investments in tax-advantaged accounts such as 401(k)s, IRAs, and the Roth versions of each.
If you invest through a taxable account, such as an account at an online brokerage, you're usually subject to certain taxes.
Generally speaking, interest payments from bonds are taxed, like bank account interest, at your normal marginal income tax rate. One notable exception is interest from municipal bonds, most of which are exempt from federal income tax.
That doesn't mean you're off the hook for state taxes, however, says David Levi, managing director of CBIZ MHM's Minneapolis office. "No states tax income from their own municipal bonds, but some tax muni bond income from other states," he says.
Video by David Fang
Dividends from stocks get special tax treatment. As part of an effort to encourage investors to buy and hold stocks, the IRS deems certain dividend income as "qualified," which means that it's taxed at your long-term capital gains rate. For most investors, that's 15%, but depending on your income, it could be as much as 20% or as little as 0%.
In order to be qualified, a dividend must be paid by a company that trades on U.S. exchanges. The investor must have also held the stock for at least 60 days during the 121-day period following a cutoff known as the ex-dividend date.
In plain English: If it's a typical stock and you've held it for a few months, the dividend payments are probably qualified.
Video by David Fang
Non-qualified dividends, known as ordinary dividends, are commonly paid by certain investments, which include real estate investment trusts, money market funds, and ETFs that invest in master limited partnerships. REITs and MLPs are a type of company known as a "pass-through." Firms with this designation aren't taxed at the federal level and pass their profits and tax liability directly through to investors.
Because of this convention, dividends from these investments don't receive favorable tax treatment and are instead taxed at your ordinary income tax rate. You can, however, usually take a 20% qualified business deduction from REIT or MLP ETF income, provided you meet certain criteria.
Each pass-through investment you own will issue a tax form known as a K-1, which, depending on the investments you own, can get complicated fast, says Levi. That's because the rules make it difficult to use losses from any investments to offset your income.
Video by Stephen Parkhurst
"It's kind of like: Heads, the government wins; tails, the taxpayer loses," he says. "There's tremendous complexity to be dealt with."
If you think you might be involved in a K-1 investment, it would be wise to chat with a tax professional, especially if you're planning on filing early. "The problem with K-1s, is they almost always come out late," says Ed Slott, a certified public accountant and founder of Ed Slott & Company. "Knowing that it's coming and how to enter the information on it correctly is key."
Tax rules around real estate are finnicky, and depending on your situation, it may once again make sense to talk with a tax pro. But here are the basics for people who earn income from real estate they directly own, rather than owning it through, say, an investment partnership.
If you rented a room in your house for 14 or fewer days last year, and you lived there the rest of the time, you don't have to report the rental income on your tax return. Once you rent for more than 14 days, you're viewed as a landlord by the IRS. All rental income, to the extent that it exceeds certain expenses on the house outlined by the IRS, is taxed at your regular income tax rate.
The same general rule holds true if you own and personally manage a rental property or if you regularly rent out part of your home to a tenant. In these cases, you'll owe regular income tax, but you can deduct expenses related to the property, such as property taxes, mortgage interest payments, property repair costs, property insurance, and depreciation.
If you are actively involved in the rental activity, for instance by doing maintenance, leasing the property, and keeping the books, you may be able to deduct a rental loss from your taxable income (in the case that the operating expenses for your properties exceed your rental income) if your income from sources other than real estate is less than $100,000. Individuals under that threshold can qualify for a deduction up to $25,000, with the amount of the deduction gradually phasing out for individuals who make up to $150,000.
Disclaimer: This is intended as general education and for informational purposes only, it is not intended as specific tax or investment advice. Please consult with a qualified professional for advice based on your personal situation.
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