Passive income and portfolio income are types of income that require minimal time and effort. They are categorized as unearned income, unlike income from a job, but are still subject to taxation.
Passive income can come from sources such as rental properties, limited partnerships, or royalties from creative projects. On the other hand, portfolio income is generated from investments like stocks, bonds, and bank accounts.
Understanding how passive and portfolio income are taxed is essential, as well as exploring strategies to potentially generate tax-free cash flow in certain situations.
Passive income vs. portfolio income: Exploring the differences
Although passive income and portfolio income both involve minimal effort to earn, the key distinction lies in the source of the income. Portfolio income typically stems from investments, while passive income can come from various sources. In most cases, both types of income are subject to taxation.
Types of passive income
- Rental income
- Royalties
- Income from limited partnerships
- Alimony and child support
- Unemployment benefits
- Worker’s compensation
- Social Security benefits
Types of portfolio income
- Dividends
- Interest from a bank account
- Bond interest
- Dividends from preferred stock
- Capital gains
- Sales of cryptocurrency
- Collectibles and non-fungible tokens (NFTs)
Even if you do not receive a Form 1099 for earnings below a certain threshold, such as interest income below $10, you are still responsible for reporting and paying taxes on that income.
Understanding the tax implications of passive income
The tax rate applied to passive income varies depending on the specific type of income and the duration of asset ownership.
Taxes on rental income
Rental income is generally considered ordinary income and is subject to federal and state taxes, unless exempted by state income tax laws. Deductions for expenses related to the rental property, such as mortgage interest and repairs, can help reduce the tax burden.
Real estate professionals may qualify for certain deductions and exemptions, including avoiding the 3.8 percent net investment income tax.
Taxes on royalties
Royalties, stemming from copyrights, patents, and natural resources, are taxed as ordinary income.
Taxes on limited partnership income
Partners in a limited partnership are taxed based on their ownership share and income from the business. They are subject to ordinary income tax rates and are not liable for self-employment tax.
Investors in master limited partnerships (MLPs) may benefit from long-term capital gains treatment on their investments.
Taxes on alimony and child support
Child support is not taxable at the federal level, while the tax treatment of alimony depends on the agreement date and specific circumstances.
Separation agreements executed on or before Dec. 31, 2018, are typically taxable to the recipient and deductible by the payor. However, agreements made after this date may have different tax implications.
Taxes on unemployment benefits
Unemployment benefits are generally taxable at the federal level and may also be subject to state taxes.
Taxes on worker’s compensation
Income from worker’s compensation is typically not taxable.
Taxes on Social Security income
Social Security benefits are generally taxable, with the amount subject to taxation dependent on the recipient’s total income.
Recipients of Social Security benefits may not owe taxes on the full amount, with some potentially avoiding taxes altogether or paying taxes on a portion of their benefit.
Understanding the tax implications of portfolio income
The tax rate applied to portfolio income is determined by the type of income and the duration of asset ownership.
Taxes on dividend income
Dividends are classified as ordinary or qualified, with qualified dividends taxed at lower rates depending on the investor’s tax bracket. Holding periods and specific criteria must be met to qualify for lower tax rates on dividends.
Dividends that do not meet the requirements for qualified status are taxed as ordinary income.
Taxes on interest from bank accounts or bonds
Interest income from bank accounts and most bonds is taxed as ordinary income. Municipal bonds, however, are typically exempt from federal taxes.
Taxes on capital gains
Capital gains from selling assets like stocks and investment funds are subject to varying tax rates based on the holding period and total taxable income.
Short-term gains (assets held for less than a year) are taxed at ordinary income rates, while long-term gains (assets held for over a year) are taxed at special rates.
Taxes on capital gains from real estate
Profit from selling real estate is considered a capital gain and may qualify for favorable tax treatment under certain conditions.
Homeowners can potentially exclude up to $250,000 (individual) or $500,000 (married filing jointly) in profits from the sale of their primary residence, provided they meet specific ownership and residency requirements.
Investment real estate sales are subject to capital gains tax rates, with potential tax-saving strategies like a 1031 exchange available.
Taxes on collectibles
Collectibles, such as art and NFTs, are considered alternative investments and are taxed at long-term capital gains rates, which can go up to 28 percent.
Strategies for generating tax-free passive income
While most passive income is taxable, there are strategies to potentially generate tax-free income within certain parameters.
Income within retirement accounts
Earnings within retirement accounts like 401(k)s and IRAs can grow tax-deferred until withdrawals are made. Roth accounts offer tax-free growth and withdrawals in retirement, providing a tax-efficient investment option.
Rental property cash flow
Landlords can deduct depreciation as a business expense, reducing taxable rental income. This depreciation shield can result in cash flow from the property with minimal tax liability.
Municipal bonds
Municipal bonds are tax-exempt at the federal level and potentially at the state level, making them a tax-efficient investment for certain investors.
0 percent capital gains rate
By optimizing the mix of assets and income, investors can take advantage of the 0 percent capital gains rate to minimize tax liability on their investment income.
Conclusion
Passive and portfolio income are generally taxable, but there are opportunities to reduce tax liability or generate tax-free income through strategic investment and financial planning. It is crucial to understand the tax implications of different income sources and explore tax-efficient strategies to maximize your investment returns.
Editorial Disclaimer: All investors should conduct thorough research on investment strategies before making financial decisions. Past performance of investment products does not guarantee future price appreciation.