Active Versus Passive Income Taxation: Your Quick & Easy Guide

Welcome to our comprehensive guide on active versus passive income taxation. If you’re striving for robust tax planning, understanding the distinction between active and passive income is essential. Whether you’re a novice in the tax world or an experienced investor, this guide will clarify these complex concepts and ensure you’re primed for the most favorable tax treatment possible.

What are Active and Passive Income Sources?

Passive and active income sources are fundamentally different, and knowing this difference is critical for tax planning. Let’s dissect the two concepts.

Active Income

Active income is the income you earn for services you provide, such as wages, salaries, commissions, and tips. If you’re actively working to generate the income, it’s deemed as active. Active income includes:

  1. W-2 income from your job.
  2. Self-employment income that you’re generating through your entrepreneurial efforts.
  3. Consulting work that you engage in.
  4. Partnership income in a business where you’re actively participating.

Passive Income

Contrarily, passive income is money you earn from a rental property, limited partnership, or other enterprise in which you are not actively involved. If you’re earning an income without actively participating, it’s generally considered passive income. Common sources include:

  1. Rental income from properties you own.
  2. Dividends and interest from your brokerage or high yield savings accounts.
  3. Capital gains transactions, like selling a stock or an ETF at a profit.


Breaking it Down with an Example

To clarify these concepts, let’s look at an example:

Assume you generated $25,000 worth of passive income primarily from a rental property. Simultaneously, you earned $100,000 in active income, predominantly from your W-2 job. After factoring in marketing expenses, repair costs, and depreciation, your rental property resulted in $35,000 in rental losses.

This situation leaves you with net passive losses of $10,000 ($25,000 in rental income – $35,000 in rental losses). Many people incorrectly assume that these passive losses can be used to offset the $100,000 active income, resulting in net income of $90,000.

However, the IRS views passive and active income in their own separate lanes. Net passive losses can generally be carried forward to future tax years to offset other passive income. But these losses cannot be used to offset active income earned from sources like a W-2 job.

This is where understanding the tax code and strategizing around passive income becomes crucial. With the right planning, your passive income can be considered active income, and thus, the losses it generates can offset your active income.

Remember, though it requires in-depth planning and strategic effort, it’s possible to leverage tax rules in your favor. Understanding the distinct categories of income and how they’re taxed will open up a world of strategic possibilities.

Wrapping It Up

Understanding the basics of passive versus active income is a pivotal step in mastering complex tax strategies, whether you’re exploring tax loss harvesting with stocks or delving into the intricacies of rental property taxation.

Revisit this guide whenever necessary and remember, knowing the rules of the game can make your tax planning much more rewarding. Below is a video breakdown of this concept for further education. If you need specific tax advice, please reach out to us. We would love to provide guidance.



Important Disclosures

MDRN Wealth LLC  does not provide specific legal or tax advice. Please consult with professionals in these areas for specific legal and tax recommendations. The information provided herein is general information. It is not intended to be construed as investment, tax, or legal advice. Information in this article is not an offer or solicitation to purchase, sell, or endorse a specific company, security, investment vehicle or strategy. Investing involves risk and the possible chance for loss of principal. Please consider your tolerance for risk before investing. Past performance is never guaranteed and future results can vary. Opinions conveyed by MDRN Wealth LLC cannot be viewed as an indicator of future performance and are subject to change. Results may vary. Use information at your own risk.

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