There are three basic types of income a person can receive, and each is taxed differently. It’s important to understand how the Internal Revenue Service (IRS) treats each of the following:
Earned income is income you receive from working at a job or operating a self-employed business. The IRS considers all of the following earned income:
Earned income is taxed at each taxpayer’s marginal tax bracket. Income tax is progressive, meaning the rate rises when more income exists.
The IRS does not consider any of the following earned income:
When you earn money from an investment, it’s considered investment income. Investment income can be grouped into three forms:
Interest and dividends are taxable in the ways we discussed in the previous chapter. At the end of each year, investors net their capital gains and losses to determine whether they have a taxable gain or a deductible loss. 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 net gain is taxable to the investor. 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 change the July 10th trade.
January 30th
March 15th
July 10th
The investor now ends with a $13,000 net capital loss. Capital losses can reduce taxes. If an investor has a net capital loss for the year, they can deduct up to $3,000 of the capital loss against other forms of income that year.
For example, assume this investor made $100,000 of earned income from their job. They can deduct $3,000 of their net capital loss, reducing taxable earned income to $97,000. That deduction lowers their tax obligation.
In this example, $10,000 of the $13,000 net capital loss is left over. Any remaining portion rolls over to the following year, where it can offset future capital gains. For instance, the investor could have $10,000 of capital gains the following year and owe no capital gains tax on those gains (because the rolled-over $10,000 capital loss offsets them).
Income received from a business in which a person does not “materially participate” is considered passive. Passive income is commonly associated with income from rental real estate properties and limited partnerships.
While passive income tax rates are the same as income tax rates, passive income is categorized separately for an important reason: passive losses can only offset passive gains.
As we learned in the direct participation programs chapters, limited partnerships pass through losses to investors. In practice, businesses often report losses in their first few years of operation. If passive income weren’t separated into its own category, investors could accumulate large limited partnership losses, use those losses to offset earned or portfolio income, and significantly reduce (or eliminate) their tax liability. The passive income rules help prevent that outcome.
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