Passive Income

Income from your side hustle could be considered "passive income" for tax purposes. Passive income is money that is (allegedly) made with very little effort.

According to the IRS, passive income includes:

• Trade or business activities in which you don’t materially participate during the year.

• Rental activities, even if you do materially participate in them, unless you’re a real estate professional.

• Certain types of limited partnership partnership income.

• Certain types of royalty income.

• Income from any activity in which you did not materially participate.

Material Participation

A trade or business activity isn’t a passive activity if you materially participated in the activity. You materially participated in a trade or business activity for a tax year if you satisfy any of the following tests:

1. You participated in the activity for more than 500 hours.

2. Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.

3. You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.

4. The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours.

5. You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.

6. The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.

7. Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.

Tax Rates

The amount of tax imposed on passive income varies depending on the source of that income, how long an investment is held, the amount earned, and your own income tax bracket.

The following types of passive income are taxed at the capital gain rates:

• Sale of property held longer than a year.

• Sale of investments held longer than a year.

• Capital gain distributions - distributions made when a mutual fund sells a holding.

• Qualified dividends - dividends paid by a U.S. company or qualifying foreign company and meet other requirements.

Data Source: Tax Foundation

There are a few other exceptions where capital gains may be taxed at rates greater than 15%:

• The taxable part of a gain from selling certain small business stock is taxed at a maximum 28% rate.

• Net capital gains from selling collectibles (such as coins or art) are taxed at a maximum 28% rate.

• The portion of any unrecaptured section 1250 gain from selling section 1250 real property is taxed at a maximum 25% rate.

Other types of passive income - sales of investments held less than a year, income from eBay sales, and other forms of side hustle income - are usually taxed at the ordinary tax rates. This means, the same tax rate applied to the wages your received from your employer applies to your passive income. Note, this tax rate also varies depending on your relationship status, household role, and taxable income.

Data Source: Tax Foundaion

As you earn passive income, you will also want to keep in mind state taxes and the net investment income tax. The net investment income tax is an additional tax of 3.8% on investment income for individuals, estates, and trusts with modified adjusted gross income over a certain threshold.

Tax Reporting

For individuals, passive income from eBay sales, ridesharing, freelancing and other types of side hustles is typically reported on Schedule C, Profit or Loss from Business (Sole Proprietorship) of Form 1040. Passive income from real estate, partnerships, and similar types of investments or passthrough entities is typically reported on Schedule E, Supplemental Income and Loss on Form 1040.

Passive income is usually a good way to increase income streams and build wealth. If you want to generate passive income and are not sure where to start, check out this list of side hustle ideas from Entrepreneur Magazine. Whatever your side hustle, always keep the tax implications in mind and prepare accordingly.

This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.