When it comes to your income tax, the IRS applies different tax rates based on whether you have an active or passive source of income. In this guide, you learn everything you need to know about passive income vs active income and how it affects your income tax liability.
Knowing the difference between passive and active income is essential to understanding what type of investor you are classified as by the IRS. Find out what the differences are between passive income and active income, and how it affects your taxes. And, explore ways to make the most of your passive investments.
Understanding Passive Income vs Active Income in 2020
The rules that determine passive income vs active income are set by the Internal Revenue Service (IRS). How the IRS classifies your activity determines the rate at which your income is taxed. Often, the IRS will tax passive income at a lower rate than that of active income.
Rental activity is uniformly categorized as passive investment activity – unless it is your primary source of income. Passive income, however, includes any investment activity in which you are not an active participant in labor. So, if you derive your income from business investments, but you are not the main contributor to the activity of the business, you are likely receiving passive income.
Are You an Active Material Participant in Labor?
The biggest difference between passive income vs active income is labor. The IRS sets some stipulations for qualifying active investment activity. You can claim your income as being active if you own and are a material participant to the business.
To be considered an active owner, annually, you must contribute at least 750 hours of labor to the business, or 500 hours if no one has contributed more.
Example of Material Participation in Labor
As an example, imagine you and two other investors buy a piece of rental property. Each of you invested equally, but your income is taxed differently based on how many hours of work you contribute in a year. One of the partners is the property manager, so their income is active because it comes from material participation in the labor of the business.
The other investor regularly makes repairs on the building and helps with day to day operations, so their income is also active. You are not involved in handling the rentals or business operations, so your income is passive.
Even if you help out with rentals every once in a while, if your labor doesn’t equal at least 750 hours for the year, it is likely passive income.
Why Passive Income Is Often Better Than Active Income
Passive income is good and bad. But, in general, it is good, because you can avoid paying 15.3% self-employment taxes. Combined with depreciation and amortization which are phantom expenses you don’t pay for each year, many times passive rental income has a much lower effect tax on the cash your rental property earns.
The IRS sets a lower tax rate for passive income vs active income. Active income is always subject to the marginal tax rate and self-employment tax. The only way to reduce your active income tax liability is to increase your expenses, thereby claiming more losses.
Real estate rentals, which generate passive income benefit from a much lower marginal tax rate. So, at the end of the day, passive real estate investments can minimize your income tax liability, in many cases.
Example of Passive Income vs Active Income Tax Benefits
If your income is from passive investment in real estate rentals, you are sheltered by depreciation and amortization. So, assume that your passive income nets $20,000, and your depreciation and amortization come out to $16,000. That means that $4,000 is what the IRS considers your taxable net income. If you are in the 37% tax bracket, you will pay a tax equal to $1,480. But when we compare that $1,480 to the amount earned ($20,000), you see an effective tax rate of only 7.4%.
If you earned that same $20,000 in earned income, you would need to spend money in order to reduce the amount subject to tax. Otherwise, you’d pay $7,400 on the $20,000 in earned income, assuming you’re in the 37% tax bracket.
With rental real estate, you don’t have to pay for depreciation each year. It’s a phantom expense that you get to claim. That’s why passive income beats earned income from a tax perspective.
Passive Investor Income Taxes vs Active Investor Income Taxes
The IRS considers an active property investor as a business unto themself, and their taxes are seen as such. Therefore, an active rental investor gets to deduct their business losses. Active investors, also, deduct expenses associated with starting-up an investment, as well as home office expenses.
Active investors can be seen as those who generate a primary income from their investments. On the flip side, passive investors are only allowed to deduct the regular costs of their properties. Home office expenses are only deductible up to the losses they generate.
Consult a Tax Professional
You can see the tax advantages to passive income vs active income. It makes the most sense to generate active income from long-term capital gains. All it takes is knowledge, and a little help from an accounting professional to get more money from your income.
If you’re ready to make the most of your income, talk to a tax specialist today to see how you can reduce your tax liability. And, share this article with your social media community to help others understand the tax liability differences between passive income vs active income.