I recently started reading "Tax Free Wealth" by Tom Wheelwright and I realized how much my knowledge is lacking on the tax side of investing. Further, I realized how confusing the different terms are for the various types of income and their different tax treatments by the IRS. To that end, I put together a cheat sheet of everything I've learned so far. I've gathered the below info from blogs, CPA websites, and the IRS website itself. Sometimes I find conflicting info, so I was hoping that any tax experts on here could review my notes and let me know if I got anything wrong? Thanks in advance!
Terms covered below:
-earned income
-unearned income
-ordinary income tax rate
-capital gains tax rate
-portfolio income
-investment income
-investment expense
-net investment income
-active income
-passive income
-non passive income
-3 types of income: EARNED (OR ACTIVE) INCOME, PORTFOLIO INCOME, and PASSIVE INCOME
-EARNED INCOME (also called ACTIVE INCOME): Earned income, such as that from wages, tips, and business participation are considered active. It is also income from business activities, such as the money you earn if you are self-employed or actively involved in managing a rental property. This is the type of income that can be reduced (offset) by contributions to your 401(k) account and tax deductions. Earned income is a direct result of your labor; usually W-2 or schedule C, both of which are subject to self-employment taxes (SS and medicare tax)
-PORTFOLIO INCOME: interest, dividends, and gains and losses from sales of assets; Taxed at ordinary income rate or capital gains rate depending upon length of holding. Capital gains is not a form of income per se, but a simply defines how your portfolio income will be taxed; Portfolio income is not subject to self employment tax but may be subject to net investment income (NII) tax; It’s important to understand that the IRS views portfolio income as distinctly different from passive income, even though it is popularly considered to be “passive.”
-PASSIVE INCOME: income that would continue to generate if you died; includes rental income, royalties, and income from businesses, investment partnerships, and LLCs where you do not materially participate; not subject to self employment tax but may be subject to net investment income (NII) medicare tax; Can label yourself as a real estate professional to allow passive losses to be deducted and to avoid NII tax on rental income; If you write a book and receive royalties, that income is passive and not subject to self-employment tax; But if you write several books and consider yourself a writer, then you are materially participating and that income is earned income and subject to self employment tax; The IRS does not allow you to use passive losses to offset your active or portfolio income. IRS: "Rentals and businesses without material participation. A limited partner is generally passive due to more restrictive tests for material participation. As a result, limited partners will generally have passive income or losses from a partnership"
NONPASSIVE INCOME: Businesses in which the taxpayer materially participates. Also, salaries, guaranteed payments, 1099 commission income and portfolio or investment income are deemed to be nonpassive. Portfolio income includes interest income, dividends, royalties, gains and losses on stocks, pensions, lottery winnings, and any other property held for investment. (From IRS)
INVESTMENT INCOME: Investment income includes, but is not limited to: interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities and businesses that are passive activities to the taxpayer (within the meaning of section 469). (Per IRS net investment income tax FAQ)
INVESTMENT EXPENSE: Investment expenses are your allowed deductions (other than interest expense) directly connected with the production of investment income. Investment expenses that are included as a miscellaneous itemized deduction on Schedule A (Form 1040) are allowable deductions after applying the 2% limit that applies to miscellaneous itemized deductions. Use the smaller of: 1) The investment expenses included on Schedule A (Form 1040), line 23; or 2) The amount on Schedule A (Form 1040), line 27. Examples of deductions, a portion of which may be properly allocable to Gross Investment Income, include investment interest expense, investment advisory and brokerage fees, expenses related to rental and royalty income, tax preparation fees, fiduciary expenses (in the case of an estate or trust) and state and local income taxes.
NET INVESTMENT INCOME: Determine the amount of your net investment income by subtracting your investment expenses (other than interest expense) from your investment income. Net investment income includes, but is not limited to: interest, dividends, capital gains, rental and royalty income, and non-qualified annuities. Net investment income generally does not include wages, unemployment compensation, Social Security Benefits, alimony, and most self-employment income. Additionally, net investment income does not include any gain on the sale of a personal residence that is excluded from gross income for regular income tax purposes.
From wikipedia on ORDINARY INCOME vs CAPITAL GAINS:
Under the United States Internal Revenue Code, the type of income is defined by its character. Ordinary income is usually characterized as income other than long-term capital gains. Ordinary income can consist of income from wages, salaries, tips, commissions, bonuses, and other types of compensation from employment, interest, dividends, or net income from a sole proprietorship, partnership or LLC. Rents and royalties, after certain deductions, depreciation or depletion allowances, and gambling winnings are also treated as ordinary income. A "short term capital gain", or gain on the sale of an asset held for less than one year of the capital gains holding period, is taxed as ordinary income.
Ordinary income stands in contrast to capital gain, which is defined as gain from the sale or exchange of a capital asset. A personal residence is a capital asset to the homeowner. By contrast, a land developer who had many houses for sale on many lots would treat each of those lots (and homes) as inventory when they are sold. For the developer, each lot and home would not be a capital asset. Similarly, clothing held by a retail store for sale in the ordinary course of business would be inventory -- and not a capital asset -- for the store.
Another case where income is not taxed as ordinary income is the case of qualified dividends. The general rule taxes dividends as ordinary income. A change allowing use of the same tax rates as is used for long term capital gains rates for qualified dividends was made with the Jobs and Growth Tax Relief Reconciliation Act of 2003.[1] Qualified dividends are dividends paid by domestic corporations or by corporations from foreign countries that have a tax treaty with the United States. This rule applies under the condition that the corporation has included the dividends in its own taxable income. Thus pass-through corporations like REITs and REMICs would not distribute qualified dividends, and the dividends from those entities would be taxed at the ordinary income rates.
From wikipedia on UNEARNED INCOME:
As defined by the American Social Security Administration, unearned income is all income that is not earned from one's job or from one's business. Some common types of unearned income are:[7]
-Annuities, pensions from any government or private source, workers' compensation, unemployment insurance benefits, black lung benefits and Social Security benefits;
-Prizes, lottery winnings, settlements and awards, including court-ordered awards;
-Proceeds of life insurance policies;
-Gifts and contributions;
-Support and alimony payments;
-Inheritances in cash or property;
-Rental income;
-Dividends and interest
