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 various ways. At the end of each year, investors net (add up) their capital gains and losses to determine whether they have a taxable gain or a deductible loss.
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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