Passive income is the holy grail of all types of incomes, but not just for the obvious reason of keeping money flowing into your pocket while you kick back and relax. No, it’s the best because you can literally pay a 0% tax rate on the passive income you make. Just like how you don’t have to worry about working to that income, you also don’t have to worry about taxes on it.
But, not a lot of people know what true passive income is, as defined by the IRS, which is really important since many people talk about it, when in reality, it’s nowhere near passive as far as the IRS is concerned. Here’s how the IRS defines passive income, how its taxed, and how you can reduce the taxes you pay on it.
How the IRS Defines Passive Income
A lot of people think that they may already know what passive income is, but the thing is, a lot of people don’t know what the IRS considers as passive income, and most of the time what they consider passive income, is actually active income in the IRS’ eyes.
For the IRS, passive income is classified into two categories: the first one is any income from a business or trade activity that you don’t materially participate in. Generally, material participation can be summarized as a business or trade activity where you are working more than 500 hours and/or you’re significantly involved in that business’ operations.
As for the second type of passive income according to the IRS, it’s the income that’s generated by any rental activities, even if you materially participate, except for activities you do to fulfill your duties as someone with a professional career in real estate. Meaning, passive activities include leasing equipment or other assets, having rental properties or limited partnerships, and owning a small business where you as an individual don’t materially participate, but are involved simply by investing money.
How Passive Income is Taxed
Any passive income you make within a year is taxed at a short-term capital gains tax rate, which is basically the same tax rate that you would pay on a federal level on your active income. For example, let’s say that you earn around $70,000 a year from your 9 to 5 job, but you’re also fortunate enough to have invested your savings, and you get an extra $30,000 a year from that in the form of passive income.
That $30,000 will affect your overall tax bill as your $70,000 income would put you in the 22% short-term capital gain tax bracket, and with an extra $30,000 from passive income, you’d be pushed into the 24% tax bracket.
Eliminate Your Taxes
No one wants to have their taxes increased like that from income that’s supposed to be comfortable and passive, so here are tips you can follow to pay little or zero taxes on your passive income.
Use Long-term Capital Gains
The first thing you can do is hold the investment that gives you passive income for the long term, so for more than one year. This can save you a lot of money in taxes, since if your passive income gets taxed at the long-term capital gains tax rate, you could pay a 0% tax rate, depending on your income level. In fact, even if you fall into the highest tax bracket, your long-term capital gains tax rate would be 20%, which is far less than the short-term rate at over 30%.
Offset Profit with Losses
Another thing you can do is offset the gains by losses. For example, let’s say you have two sources of passive income; a rental property and a company that you aren’t materially participating in, but have invested some money into.
Now, let’s say you get really good income from the rental property, but the business is losing money and not earning you that much. You can use that to your advantage if you don’t want to pay taxes on the income from the rental property by deducting a loss of up to $3,000 from the overall tax bill on your passive income since your business is losing money, and that is a strategy a lot of people use to reduce taxes on their passive income.
Keep in mind that when you record a loss on a passive activity, only passive activity profits can have their deductions offset instead of the income as a whole. In other words, you can’t offset profits from your active income using losses from passive activities. In addition, a great tax benefit for rental properties is that you can deduct the costs of the property’s depreciation and all the other costs you spend on improvements from your passive income tax bill.
Maximize Your Tax Deductions
Another good way to avoid paying a lot of taxes is to maximize your tax deductions, so you can retain more of your active income and delay taking your passive income to avoid paying taxes on it. By taking this approach, you delay using your passive income to not pay taxes on it, and when you actually need to take it, it’ll likely be at a time when you have low income and really need the money, so you’d fall into a lower tax bracket and pay less taxes.
There are a lot of ways you can maximize your tax deductions, including making charitable donations and saving up for retirement, but we’ve covered those in an older article about 2024’s new marginal tax rates, so make sure to check it out if you want to learn more about them. What we’re going to do here instead, is talk about some overlooked tax breaks which can be used to maximize deductions and a lot of people don’t consider them.
Reinvested Dividends
For starters, there are reinvested dividends. If you earn income from dividends, you can reinvest that money in extra shares, and each reinvestment will increase your “tax basis” in the stock or mutual fund that you receive the dividends from. This, in turn, reduces the amount of the taxable capital gain you have when you sell your shares.
Self-employed Tax Deductions
Another overlooked tax deduction is one that you can get if you’re self-employed or a freelancer, as the IRS allows you to deduct costs like the money you spend on office equipment and supplies, furniture, business travel, and many more. Some of the most overlooked ones though are the costs of getting professional licenses and continuing education.
Energy Tax Deductions
You can also get a tax deduction if you install energy-efficient improvements to your home, which can be things like solar panels or solar-powered water heaters for the water you use inside your home. If you buy an EV, the same thing applies. You can get a tax credit ranging from $3,750 to $7,500 for buying a new EV, or $4,000 for buying a used one.
But, you need to keep in mind that each of these deductions have specific criteria that need to apply to you first, so you need to check the IRS’ website first to see if you can actually get these deductions, or even consult with a tax professional.
Tax-free Passive Income
If ways to reduce taxes still sound like too much work, then you could try investing in passive income sources that aren’t taxable. For example, you could buy tax-free municipal bonds. These bonds are debt instruments that fund state and local infrastructure projects, and carry a relatively low risk of default. The income from these bonds and bond funds is not taxed at the federal level, though you may pay state or local income tax on them.
There are several municipal bonds funds available from investing firms like Vanguard, Fidelity and iShares, with very low expense ratios and solid returns. For example; the Vanguard Tax-Exempt Bond Index Fund (NYSEARCA: VTEB) is currently paying out more than 3% in tax-free dividends yearly, and has an expense ratio of 0.05%.
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