How Is Passive Income Taxed? The Answer Isn’t So Simple

How is Passive Income Taxed

No matter how much money you earn, there is always going to be the chore of preparing to pay income taxes. If you’re low income or meet other criteria you may not have to pay any income taxes. But for anyone who is ¬†self-employed or running a small business and earning over $400, the law states you must complete your federal tax return.

One area of some confusion is that relating to passive income. The term is used to describe all manner of revenue streams and types, however, for taxation purposes that definition is a lot narrower than you may think.

In this article, we’ll explain what those differences are and try to give you some clarity in relation to how what you may perceive as passive income is taxed.


First Things First

We’re not tax attorneys or certified tax advisers so all the information we provide here is not intended or offered as legal or formal taxation advice. If you have any queries, issues, or difficulties in relation to your tax affairs then the best advice we could possibly give you is to seek out a professional tax advisor.

Remember, there are severe penalties for failing to file proper and accurate tax returns and so merely reading articles such as this is not the way to put your tax affairs in order. By all means, read on to add to your own research, but when it comes to making sure your tax return is 100% correct, you should use a certified public accountant or similarly qualified tax professional.

What is Passive Income?

The term passive income is often used in the business community as income which is generated on a continual basis, long after the initial work which produced that income in the first place was completed.

Another way passive income can be earned is membership sites, where a customer pays a subscription each month in return for receiving information, access to software, or a monthly delivery of physical goods, such as food hampers.

The reason these types of businesses are called ‘passive’ is that the activity of selling the customer the product, and often in producing the product itself, has often happened some time ago. This means that the business owner or the affiliate is continuing to receive an income, but they are often not doing anything that might be considered proactive to generate it.

However, there is one huge issue with calling this or any other similar revenue stream ‘passive’ because, in terms of how income is taxed, they are not passive as far as the IRS is concerned.

How the IRS Define Income Types

As far as the IRS is concerned there are three distinct types of income which you can earn. It’s important to understand the difference between these so you can know how tax brackets work.

Active Income

The first is active income which basically relates to any income which you earn performing a job or service. This includes manual labor such as a gardener, service jobs, such as waitressing, and professions such as a dentist.

Active Income is taxed according to the tax brackets laid out here.

how is passive income taxed

Portfolio Income

The next type of income is portfolio income. This will be income that someone receives as a result of interest and capital gains, investments, share dividends and if any royalties are received in respect of a property investment, that can also be classed as portfolio income too. This type of income is taxed at the same rate as other forms of passive income. Depending on the amount of income and how long you have held the asset here are the current passive income rates… .

The current tax rates for short-term gains are: 10%, 12%, 22%, 24%, 32%, 35% and 37%.

The current tax rates for long-term gains (asset owned for more than one year) are: 0%, 15% and 20%, based on your income bracket.

Passive Income

The third type is passive income, and this where we need to consider carefully how the IRS defines it, compared to what is usually called passive income in the business world.

For tax purposes, the IRS considers passive income as coming from only two clearly defined sources.

The first is rental activity, where you receive income from those paying rent to live in a property you own, or part own. The second is income from a business in which you ‘do not materially participate.’ It is at this point that the words ‘materially participate’ need to be examined.


Material Participation

While it can be argued that many online business opportunities provide you with a business that is both lucrative and requires the minimum of effort, it cannot be said that you are not participating in that business.

The same applies to you running a membership site where you may have created the content for it in advance. There will still be activities that you need to perform for that business such as customer support, uploading the content, processing refunds, and actively promoting it to obtain new subscribers.

Generic definitions from the IRS which constitute material participation include being the sole participant in that business, so if you are working for yourself that applies. If you work at least 500 hours in the year, which is only 2 hours per working day, you’re also considered active.

Even if you only work 100 hours, which is just 40 minutes per working day, but at least one other person works with you on your business, that is also material participation. You may not be working a full 9 to 5 shift every day, and the income may seem to be passive, but for tax purposes you are active.

How your ‘Not-Passive’ Income is Taxed

While it may be called passive in internet marketing circles, the income you earn online will be treated as active income for tax purposes. That doesn’t mean you can’t reduce what you pay in taxes. But you need to follow the advice of your tax expert. They can guide you in what you can write off against your business and what you can’t.

C. James

C. James is the managing editor at Wealth Gang. He has a degree in finance and a passion for creating passive income streams and wealth management.