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Passive income is the ultimate: regular income with little effort.

What is Passive Income?

From the IRS point of view passive income is any income that you get without having to materially participate in. Passive income is money obtained on a regular basis with little effort. Examples include:

• Rental income
• Renewal income – income from subscription renewals
• Royalties – from book publishing, patents, etc.
• Advertising income – from online ads such as Adsense
• Business income – from nondirect involvement in a business such as limited partnerships
• Dividends and interest income
• Pensions

Tax Benefits

Unlike earned income, passive income has great tax benefits. Earned income is subject to self-employment tax which is just over 15.5% (if you’re a W2 employee, your employer pays half of this). Passive income isn’t subject to this tax. If you own rental property, you also claim depreciation. Depreciation is the replacement cost of equipment used in a business and is spread out over its useful life. For residential real estate, the IRS deems the useful life to be 27.5 years. However, the useful life of a house could well exceed 60 years. This results in you being able to claim a tax loss which doesn’t really result in any loss to you. Because of this, depreciation losses are sometimes termed as phantom losses.

Rental Income Example

Let me give an example. Suppose you buy a rental property for $325,000. The tax bill says the land is worth $50,000 and the improvements (everything else that’s built on the land) are worth the remaining $275,000. Based on the IRS’s straight-line depreciation method of deducting the cost of the improvements over 27.5 years, you get to claim $10,000 a year in depreciation. Assuming you have a mortgage of $275,000 at 5%, you’ll pay about $13,750 in mortgage interest payments. Assuming the property tax rate is 1.5% and the insurance and miscellaneous expenses are another 0.5%, you’ll be paying another $6000/year. You have total actual expenses worth $19,750 per year plus depreciation loss of $10,000 bringing your grand total to $29,750. If you’re getting $1750 per month in rent, that works out to $21,000 worth of rental income. Since your actual costs are $19,750, you’re making a profit of $1,250. However, according to IRS passive income rules, you’re technically making a $8,750 loss!

Not only do you not pay taxes on your $1,250 worth of rental income, but you also get to deduct the $8,750 phantom loss from your regular earned income! In a 30% tax bracket, that is a $3,000 tax saving! You can deduct up to $25,000 worth of passive income losses on your taxes every year! If you have more losses, you can carry these forward until you can offset them against passive gains (like the sale of the property).

The flip side to this rule is the depreciation recapture rule which means you need to add back in the depreciation losses when you sell the property. However, this can be somewhat avoided by the use of a 1031 property exchange (also called a Starker exchange).

Stock Dividends

Qualified stock dividends are also another form of passive income that attract favorable tax rates. Instead of being taxed as ordinary income, the maximum tax rate is now 15% for most people. In fact, if your tax rate is 10% or less, you’ll pay only 5% income tax on your qualified dividends! There are certain restrictions that come with these lower taxations. The corporation issuing the dividends must be a domestic US corporation or a qualified foreign company. There is also a holding period of 60 days before the ex-dividend date and 59 days after the ex-dividend date.

Partnerships

Partnership income, from master limited partnerships (MLP) for example, generally has depreciation or depletion credits that lower the cost basis of your purchase.

The IRS definitely gives a lot of tax benefits to passively earned income. If you get paid as a W2 employee, you have the least number of tax breaks and will usually pay the highest taxes.

Please consult your tax adviser before you make any financial decisions. If you’re subject to exemption phase-outs or AMT this advice may not apply to you.