The savvy investor understands two things:
- Taxes are life’s greatest expense
- Not all income is taxed the same
When you fundamentally understand and embrace those two truths, everything changes.
- You will start thinking about your time differently.
- You will start thinking about your investments differently.
- You will start making your financial decisions differently.
In this article I cover:
- What is Active Income and how is it taxed?
- What is Passive Income and how is it taxed?
- The Magic of Converting Passive Income into Active Income
And remember, it’s all setting the stage for: The Single Best Tax Saving Strategy for High Income Earners
What is Active Income?
The simple answer is any kind of income you derive from actively working on something.
The most common example is your 9-5 day job. Since you are “actively” participating in your full-time job, the IRS would classify that as Active Income.
If you are self-employed your business income is considered Active Income as well.
That side hustle you’re working on? Active Income.
If an individual is physically present and materially participating in the activity, it is considered active income.
Common Sources of Active Income:
- Your day job
- Your small business
- Your side hustle
How is Active Income Taxed?
Active Income is taxed as Ordinary Income.
Ordinary Income is taxed on a progressive scale, meaning the more income you earn, the more marginal tax you will pay.
If you are a high income earner at the top tax bracket, you will pay 37% federal income tax on the margin – meaning the next dollar.
What is Passive Income?
Passive Income, as the name would suggest, is any income you derive from activities in which you do not materially participate.
It’s actually quite self-explanatory.
If you’re not working on something actively, yet you are earning income from it, it’s likely passive income.
There are really two buckets of passive income:
- Income generated from a rental activity, or
- Income generated from a business you own, but do not play an active role in
How is Passive Income Taxed?
Passive Income is also taxed as Ordinary Income.
Wait… if both Active and Passive Income are taxed at the same (unfriendly) rates, why should you care about converting one to another?
The Magic of Converting Passive Income into Active Income
The IRS draws a line in the sand.
Losses from passive investments in businesses or real estate can offset income from those same or similar passive investments.
Passive Losses can offset Passive Income. Active Losses can offset Active Income.
But can the two mix? Can Passive Losses offset Active Income?
Well it depends…
If your household earns less than $150,000 per year, you can use up to $25,000 in passive losses to offset active income.
But if your household earns more than $150,000 per year… well… you’re out of luck.
You will not be able to use passive losses to offset your active income.
If you’re wondering why this matters in the first place, now’s a good time to check out:
Fortunes have been made by savvy real estate investors who combine the powerful forces of (1) Leverage and (2) Bonus Depreciation to generate huge losses on their investments.
Converting passive losses into active losses, and using those losses to offset income from their high paying day jobs.
The IRS rewards like-for-like. It’s important that we play by their rules.
1. What about FICA taxes?
We can’t end this article on the magic of converting passive income into active income without a quick nod to our lovely FICA taxes.
I want to be comprehensive in my review and give you all the facts.
Remember when I implied that both active and passive income are taxed at the same ordinary rates? Well that’s partially true. They are both taxed as ordinary income.
However, Active Income is considered Earned Income by the IRS.
And Earned Income is subject to Social Security and Medicare taxes totaling 15.3%, up to a certain level of income.
2. What is capital gain income and is it considered active or passive income?
A capital gain is created when an asset is sold for more than it was purchased for.
It does not matter whether you are actively or passively participating in an asset that generates a capital gain. Capital gain income is taxed on a different schedule.
Capital gains are either short-term, meaning you owned the asset for less than 365 days, or long-term, meaning you owned the asset for more than 365 days.
Short-term capital gains are taxed at ordinary tax rates.
Long-term capital gains are taxed at 0%, 15%, or 20% based on the investor’s taxable income level and filing status.
Long-term capital gains are therefore preferred to short-term capital gains.
3. Are dividends considered passive income? How are dividends taxed?
Dividends are considered portfolio income, which is a type of passive income.
However, dividends are taxed differently based on whether they are qualified or nonqualified.
- Are paid by US company (so you’re dividends from Apple stock would count)
- Must be held for 60 days after they are issued (before selling)
- Are taxed based on the more favorable long-term capital gains rate
Non-qualified dividends “Ordinary Dividends”:
- Anything non considered a qualified dividend, including distributions from real estate investment trusts (REITs)
- Are taxed as ordinary income… ouch