Passive income, part 2: How is it taxed?

As we know, passive income is quite simply the most effective and desirable way to reach your financial goals. After all, making money while you sleep is a win-win for everybody. In part one of this blog series, we discussed whether or not passive income is taxable. This week, let’s dive into the way it is taxed.

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To recap, passive income is the money earned from investments, rental properties, and other sources that require little or no active involvement. While it’s incredibly prudent to consider ways to generate passive income, it’s equally important to understand how it is taxed.

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Types of passive income

There are two types of passive income: portfolio and non-portfolio. Portfolio income includes dividends and interest from investments such as stocks, bonds, and mutual funds. Non-portfolio income includes rental income, income from limited partnerships, and other sources.

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Taxation of passive income

Passive income is taxed differently than earned income. Earned income, such as wages and salaries, are subject to income tax, Social Security tax, and Medicare tax. Passive income, on the other hand, is generally subject to income tax only.

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The tax rate for passive income depends on the type of income and the taxpayer's income level. For example, if you earn rental income, you will need to report it on your tax return and pay income tax on the amount earned. The tax rate for rental income depends on your tax bracket.

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Deductions for passive income

One advantage of passive income is that it is often deductible. For example, if you own a rental property, you can deduct expenses such as mortgage interest, property taxes, and repairs from your rental income. These deductions can help reduce the amount of taxable income you have.

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Passive income and self-employment tax

Passive income is generally not subject to self-employment tax, which is a tax on earned income for self-employed individuals. However, there are some exceptions. For example, if you earn rental income and provide substantial services to your tenants, the income may be subject to self-employment tax.

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In conclusion, passive income is a remarkable way to earn money, but it is important to understand how it is taxed. By understanding the tax implications of different types of passive income, you can make informed decisions about your investments and other sources of income.

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It is also important to note that tax laws and regulations can change over time. This means that it is important to stay up to date on changes to tax laws that can impact your passive income, so you may want to consult with a tax professional for advice on how to best manage your passive income and reduce your tax liability.

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In addition to understanding taxation of passive income, it is also important to be aware of potential risks associated with passive income investments. For example, investing in stocks or mutual funds carries some risk, as the value of these investments can fluctuate over time. Similarly, investing in rental properties or limited partnerships carries its own set of risks.

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Overall, passive income can be a valuable source of income, but it is important to approach it with caution and an understanding of the potential risks and tax implications. By doing so, you can make informed decisions about your investments and work towards building a more secure financial future — and at the end of the day, that’s what it’s all about.

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