There are three basic categories of income a person can obtain, all of which are taxed differently. It’s essential to understand how the Internal Revenue Service (IRS) treats each for tax purposes.
When an individual earns money from a job or a self-employed business, it’s considered earned income. This includes:
Earned income is taxed at each taxpayer’s marginal tax bracket. In a previous chapter, we discussed how income tax is progressive, meaning the rate goes higher when more income exists. The IRS does not consider any of the following earned income:
When an individual earns money from an investment, it’s considered investment income or portfolio income. We’ve discussed dozens of different securities and the various ways they make returns for investors, but investment income can be condensed into three forms:
Interest and dividends are taxable in the way we discussed previously - qualified dividends are taxed at lower rates (0%, 15%, or 20%) than non-qualified dividends (up to 37%), while interest is generally taxable at the investor’s tax bracket. For capital gains, investors must net out their realized gains and losses to determine if they owe taxes. Let’s work through an example:
January 30th
March 15th
July 10th
If these three trades were the only ones placed during the year, the investor has a $4,000 net capital gain (gains are netted against losses). The investor would be required to pay a tax on the net gain. Of course, the tax rate depends on whether the gains were long-term (0%, 15%, or 20%) or short-term (up to 37%).
What happens if there’s a net capital loss for the year? Let’s use the same figures, but tweak the July 10th trade.
January 30th
March 15th
July 10th
The investor now ends with a $13,000 net capital loss. Losing money on an investment is never fun, but capital losses reduce taxation. If an investor has a net capital loss, they can deduct up to $3,000 of the capital loss against earned income that year. If this investor made $100,000 from their job, they could deduct $3,000 to bring their taxable income to $97,000. The deduction results in a lower tax obligation.
Continuing with this example, $10,000 of the $13,000 net capital loss is leftover. Any leftover portion “rolls over” to the following year, which helps the investor avoid taxes on future gains. The investor could make $10,000 of capital gains the next year and not pay any capital gains taxes (the rolled-over $10,000 capital loss offsets it).
When an individual makes income from a business they do not manage or actively control, the income is considered passive. Passive income is typically obtained when an investor receives income from rental real estate properties and limited partnerships. While passive income tax rates are the same as income tax rates, they’re categorized as passive for a purpose: passive losses can only offset passive gains.
The IRS keeps passive income in its own category to prevent wealthy individuals from avoiding taxes. As we learned in the DPP chapter, limited partnerships pass through losses to investors. In the real world, businesses often experience significant losses in their first few years of operation. Suppose passive income wasn’t categorized the way it currently is. In that case, investors could rack up significant losses on limited partnership investments, offset their earned or portfolio income with those losses, and effectively pay no tax.
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