Passive income is defined as something you earn on a regular basis through little or no effort. Once you’ve got your income stream set up the way you want it, you will be able to essentially receive the fruits of your labor. Since you are earning money, you have to declare your passive income. Just like with active income sources such as a salary and business revenue, passive income is also taxable by the IRS. However, passive income is treated a little differently from your sources of active income. This article will discuss the differences in the treatment. It will also be a step-by-step guide on how you can report your passive income to the IRS.
1. Know which income streams are categorized as passive income.
To be able to correctly declare your passive income, you must first be able to categorize whether a particular income stream falls under the passive heading. It is important that you use the IRS definition as a guide since various institutions have their own definition of what makes up passive income. For the IRS, the income you enter falls under one of three categories. This would be active income, passive income and the final category as portfolio income.
This is where it gets a little tricky. For you and other financial institutions, dividends from investments are often part of your passive income stream because you don’t really do any work for that money. That may be true on the basic definition but not for the IRS, which categorizes it as portfolio income.
The IRS defines passive income more narrowly than the rest. For them, passive income can only come from either rental income or any business activity in which you do not participate materially.
2. Compute your passive income and deductions.
You have to figure out your net income or loss from your passive activities. This would mean computing the income you generated through passive activity and making the necessary legitimate deductions from that figure. You can actually declare self-charged interest income and deductions in the passive category if the proceeds from your loan are used as part of your passive actions. This would include any loan agreements that you have made with the business entity that you have a stake in but do not actively manage. Another deduction would also include losses from dispositions of any rental property that you might have.
3. Segregate your activities and group them together.
The IRS has stated that you can group together passive income activities into economic units. These economic units measure either gain or loss. Once you have grouped them together, each cluster can then be treated as a single activity. This makes it undeniably easier for you in the succeeding processes. You only need to prove that you don’t have any material activity for the entire cluster. You don’t have to repeat it for every element.
You are required to disclose to the IRS any changes that you make with regards to the groupings. That would include forming a new group, regrouping, or adding an element to an existing group.
4. Create a report of you passive activities.
The IRS has made it easy for you to create a report of your passive activities by developing a step by step worksheet system that will guide you throughout the entire process. The first step in the process is to complete your tax forms before computing for any passive activity limits that you might have. The second step is to take a look at Form 8582 and complete any worksheets that are relevant to your passive income activity, and there are about seven worksheets that are relevant to Form 8582. You can now finish up your report and submit to the IRS.
Declaring any passive income might be difficult for someone who has only been declaring active income for the last few years. If you find yourself in a bind, don’t hesitate to contact the IRS for any tax help that you might require. You can visit the IRS website, contact them via phone or even walk-in into your nearest IRS office. I personally prefer to use TurboTax because it is an easy to file and makes all of the steps easy to follow.
Tell us about your experience. How easy or difficult was it to declare your passive income to the IRS?