• 347
    Shares

Have you ever wondered how the wealthy pay so little in taxes relative to their income?  In fact, you may wonder do rich people even pay taxes?  Truthfully, there are many methods to lower your effective tax rate, which is why when you make an income with two commas, it behooves you to hire a savvy accountant.  Maybe you should take a page from their playbook and learn how to pay zero tax on your income as well.

But one of the more popular methods utilizes the different tax treatment of capital gains, or the profit received from the sale of an investment or property, compared to ordinary income.

The IRS taxes short-term capital gains at the equivalent of your marginal income tax rate.  For long-term capital gains, they tax at 0%, 15% or 20%, depending on your annual taxable income.

As you can see from the chart below, if your income exceeds $510,300 and you can manage to hold an investment for longer than a year, it makes a lot of sense to do so.  When you sell after a year, there’s a 17% difference in tax rate you’ll pay on your long-term capital gain.

Related: How to Save Money and Live Within Your Means

Short- and Long-Term Capital Gains Tax Rates for Single Taxpayers

IncomeShort-Term Capital Gains Tax RateLong-Term Capital Gains Tax Rate
≤$9,70010%0%
$9,701 - $39,37512%0%
$39,376 - $39,47512%15%
$39,476 - $84,20022%15%
$84,201 - $160,72524%15%
$160,726 - $204,10032%15%
$204,101 - $434,55035%15%
$434,551 - $510,30035%20%
$510,301+37%20%
Short-term capital gains tax is the tax paid on profits from the sale of an asset held <1 year
Short-term capital gains tax rate is equal to your applicable federal marginal income tax rate

After tax reform in 2018, the biggest spread comes in the in the $204,101 – $434,550 income range.  This differential is 20% and the largest gap between short-term and long-term gains.

If you find yourself in this tax bracket, it makes the most sense to delay taking a capital gain until at least year has passed assuming the asset won’t dramatically decrease in value as a result.

The same table for married, filing jointly taxpayers appears below.

Short- and Long-Term Capital Gains Tax Rates for Married, Filing Jointly Taxpayers

IncomeShort-Term Capital Gains Tax RateLong-Term Capital Gains Tax Rate
≤$19,40010%0%
$19,401 - $78,75012%0%
$78,751 - $78,95012%15%
$78,951 - $168,40022%15%
$168,401 - $321,45024%15%
$321,451 - $408,20032%15%
$408,201 - $488,85035%15%
$488,851 - $612,35035%20%
$612,351+37%20%
Long-term capital gains tax is the tax paid on profits from the sale of an asset held >1 year
Long-term capital gains tax rate depends on your income range

Related:

How to Pay Zero Tax – Why You Want Passive Income

If you need more evidence of why passive income is the best type of income after tax reform, look no further than the chart above.

Passive income can receive the same tax treatment as long-term capital gains.  This means money you earn from qualified passive activities receives preferential tax treatment, thereby making it a superior type of income compared to ordinary income.

Passive income also has the benefit accruing without active effort on your part.  Purchase a dividend-paying stock through commission-free services like Webull or Robinhood and hold on while the payments hit your brokerage account.

And if you see the upper end of the 0% tax range shown above, you’ll see just how to pay zero tax on your income: make it passive!

Naturally, passive income comes from passive activities.  Non-passive activities (otherwise called active) are businesses in which the taxpayer works on a regular, continuous and substantial basis.

Passive income does not include salary, portfolio, or investment income.  In general, the IRS considers an activity passive if it involves rentals or any business in which the taxpayer does not materially participate.

The IRS uses material participation as a test to meet the passive income standard.  Some of the ways to meet the material participation categorization (and thus not have this activity qualify as passive) include:

  • Being the sole participant in the business during the year
  • Working at least 500 hours in the endeavor during the year
  • Working at least 100 hours and as much as any other individual at the business during the year
  • Working at least 100 hours in the activity and a total of more than 500 hours at all passive activities for the taxpayer
  • Having materially participated in at least 5 of the past 10 tax years
  • For personal services businesses, having materially participated in three previous tax years at any time

A final facts and circumstances test allows the IRS to consider whether you engaged in regular, continuous, and material participation in the activity during the year.  However, you still need to work at least 100 hours in any circumstance.

Related:

How is Rental Income Taxed?

When asking yourself, “how much tax do I pay on rental income?”, you should know the IRS considers income from rental activities as passive.  Therefore, it disallows rental income as a loss you can take against your non-passive income. However, despite rental income being considered income from a passive activity, the tax code still taxes this income at ordinary income rates.

This means you cannot have a disallowed (passive) loss offset ordinary (active) income unless you meet the “Mom and Pop” exception.

For small landlords with modified adjusted gross income (MAGI) under $150,000 ($75,000 if married filing separately), they may deduct up to $25,000 in rental losses against their non-passive income.  This amount phases out between $100,000 and $150,000.

If your MAGI exceeds $100,000 ($50,000 if married filing separately or single), the $25,000 maximum deduction amount ($12,500) is reduced by 50% of each dollar over $100,000 ($50,000).  To illustrate, if your MAGI is $120,000, the maximum $25,000 deduction is reduced by $10,000 (50% * $20,000), leaving $15,000 available from the deduction against your ordinary income.

Assuming you don’t qualify as a real estate professional, this exception might benefit your tax bill come tax time each year.

A major difference used in the Mom and Pop exception is its use of the active participation standard, not to be confused with the material participation standard.  Active participation is a less stringent standard and is intended to make it easier for individuals, who cannot be considered real estate professionals, to qualify for the Mom and Pop $25,000 rental loss deduction against ordinary income.

To qualify for active participation, the taxpayer must have a greater than 10% ownership interest in the property and participate in management decisions.  Some examples include screening and approving tenants, agreeing to rental terms, and approving maintenance and service expenses for the property.  This standard has no specific hour requirement.

Some other benefits of being a landlord are using MACRS depreciation and classifying the real estate under Section 1231 property rules.  If you own multiple rental properties and are organized as a business under a strong brand, when you sell, you may need to file Form 8594, Asset Acquisition Form.

Related:

Which Types of Passive Income Qualify for LT Capital Gains?

I should point out the importance of making sure your passive income qualifies for long-term capital gains treatment.  As mentioned above, if you sell an asset held for longer than a year and realize a capital gain, the IRS treats this as a long-term capital gain.

Likewise, corporations can pay dividends, some of which are considered “qualified” and meet the long-term capital gains treatment.  For reference, a dividend is generally considered qualified if it is paid on stock you held more than 60 days during the 121-day period that began 60 days before the ex-dividend date.  This is the first date new investors are not entitled to receive the stock’s next dividend.

For any dividends not meeting those requirements, they are considered ordinary dividends and are taxed at ordinary income rates.  Some other examples which do not satisfy the qualified dividend treatment are:

  • Master limited partnerships (MLPs)
  • Real estate investment trusts (REITs)
  • Dividends paid on employee stock options
  • Dividends paid by tax-exempt companies
  • Dividends paid on savings or money market accounts

Passive Income Received from Crowdsourced Real Estate Platforms

In recent years, FinTech companies like FundRise, PeerStreet, YieldStreet, DiversyFund, and RealtyMogul and others have become a popular alternative to traditional real estate investing.  These services enable long distance real estate investing and crowdsourced ownership of real estate assets which produce passive income akin to that described above.

In fact, experienced and inexperienced real estate investors alike can participate in this new and unique opportunity to tap into a traditional path to building wealth for less capital commitment.  However, what type of tax treatment does crowdsourced real estate receive?

In broad strokes, two types of investors exist: accredited and non-accredited.  Strictly speaking, an accredited investor has more investment options than non-accredited investors, all things being equal.

As a specific call out: a handful of these services mentioned above only allow access to accredited investors 

  • Earned income in excess of $200,000 (or $300,000 with a spouse) for each of the last two years with reasonable expectations for that amount this year, OR
  • Has over $1,000,000 in net worth (with or without a spouse), excluding the equity in a primary residence

For accredited investors, they will often invest in equity projects through these services (i.e., FundRise, PeerStreet and YieldStreet).  In simpler terms, this means the accredited investor actually becomes an owner or partner in a company, often in an LLC (Limited Liability Company) or LP (Limited Partnership).

Profits and losses from LLCs pass through to investors. These company structures are therefore referred to as pass-through entities.  Because of this pass through nature, the LLC does not pay any taxes, rather accredited investors pay taxes on their personal returns.

Another common form of real estate crowdfunding investment occurs through debt financing. For this investment type, non-accredited investors can participate and do not own equity in a company. Instead, these investors treat the income received as interest income.

Most debt structures allow investors to buy shares in a fund, sometimes called eREITs. FundRise allows this option to non-accredited investors.  In this scenario, these investments act similarly to investing in a stock or bond in terms of tax treatment.  Following this initial investment, the LLC will then invest in specific real estate projects.

Looking specifically at a hypothetical example from FundRise, the treatment of dividend types may differ due to a number of factors.  The company’s eREITs allow non-accredited investors to participate and as an investor in any REIT (real estate investment trust), they should receive a 1099-DIV tax form.

This form includes pertinent information on dividends paid to the investor in a given tax year. Depending on the results of operations for the firm, REIT dividends can classify as ordinary dividendsqualified dividends, or a return of capital, all of which receive different tax rates.

In fact, when invested in FundRise’s eREIT product, in a given year, an investor’s dividend may comprise a combination of each of these types of dividends.  Generally speaking, REITs do not regularly issue qualified dividends.  For dividends to qualify for the long-term capital gains rate, the income generally would already have faced taxation, which is not how the REIT structure tends to operate.

Actually, a primary advantage of the REIT structure is to avoid taxation at the fund level and instead pass these payments through to the individual investor.  Therefore, the amount an investor pays in capital gains tax will also vary based on their tax bracket and annual income.

What REITs do provide, however, is a return of capital, also called a non-dividend distribution.  A return of capital distribution reduces the shareholder’s cost basis and faces taxation as a capital gain when the investor redeems their investment.

Because long-term capital gains face lower rates, non-dividend distributions may serve as a beneficial distribution from a tax savings prospective.

Sam over at Financial Samurai does a great job of laying out the tax implications further for these crowdsourced real estate investments.

The Net Investment Income Tax

Another tax which you need to pay attention to is the net investment income (NII) tax.  The IRS has the NII lay on top of your capital gains and applies to whichever is smaller: your NII (investment gains less investment losses and expenses) or the amount by which your MAGI exceeds the amounts listed below.

The income thresholds which make investors subject to this additional tax are $200,000 for single or head of household taxpayers, or $250,000 for taxpayers who file as married, filing jointly.

This means if you earn ordinary income of $250,000, NII of $100,000 and classify yourselves as married, filing jointly, you’ll pay $3,800 (3.8% of $100,000) on top of your 15% long-term capital gains tax rate.  You may also have to pay state income taxes, depending on where you live.  Swell, isn’t it?

Related: How to Make a Lot of Money and Fail Financially

What is the Saver’s Credit?

Another way to lower your tax liability is by taking advantage of the Saver’s Credit.  The credit, formerly called the Retirement Savings Contribution Credit, gives a special tax break to low- and moderate-income taxpayers who choose to save for retirement.

The Saver’s Credit comes in addition to other tax benefits received from saving in a tax-advantaged account like an individual retirement account (IRA).  If you qualify for this credit, it can reduce or even eliminate your tax bill.

Depending on your adjusted gross income and tax filing status, you can claim the non-refundable credit for 50%, 20% or 10% of the first $2,000 contributed during the tax year to a retirement account.  The math behind that leads to 2018 Saver’s Credit claims of $1,000, $400, or $200, respectively.

I’ll note again the non-refundable status of this credit.  Unlike refundable credits like the earned income tax credit, which can trigger tax refunds, non-refundable credits forfeit any excess, unused portion.  In the case of the Saver’s Credit, those dollar figures which don’t offset your tax liability don’t come back to you.

Using the passive income you earned to contribute to a tax-advantaged account can further compound your ability to pay zero tax.  The biggest credit amount goes to couples using the married, filing jointly status and can amount to $2,000.

Of note, if you or your spouse took a taxable distribution from your retirement account in the previous two years, this distribution reduces the size of the Saver’s Credit available to you.

Currently, the accounts which qualify for the Saver’s Credit are:

  • 401k
  • 403(b)
  • 457 plan
  • Simple IRA
  • SEP IRA
  • Traditional IRA
  • Roth IRA

To be eligible for the credit, you must be 18+, cannot be a full-time student nor claimed as a dependent on someone’s tax return.  The maximum adjusted gross income for Saver’s Credit eligibility in 2018 is $63,000 for a married, filing jointly couple, $47,250 for a head of household, and $31,500 for single taxpayers.

As your income increases, the Saver’s Credit phases out.  For reference, see the Saver’s Credit table below for credit amount by filing status and adjusted gross income.

CreditMarried, Filing JointlyHead of HouseholdIndividual
50%<$38,000<$28,500<$19,000
20%$38,001-$41,000$28,501-$30,750$19,001-$20,500
10%$41,001-$63,000$30,751-$47,250$20,501-$31,500

To claim the Saver’s Credit, use Form 8880Credit for Qualified Retirement Savings Contributions.

How to Pay Zero Tax – Use these Different Tax Preferences to Your Advantage

From the tables above, you can see from the federal level how to pay zero taxes by generating qualified passive income.  Specifically for qualified passive income (long-term capital gains) tax rates in 2019, if you make $39,375 for single taxpayers and $78,750 for married, filing jointly taxpayers, you fall into the 0% tax rate.

Of course, these income levels are tax-free (not including the consequences of state taxes) if you don’t also make ordinary income above those levels plus your respective standard deduction to push you into the 15% long-term capital gains bracket.

In other words, if you make $12,200 (2019 standard deduction for single taxpayers) of ordinary income as a single taxpayer and $39,375 of qualified passive income ($51,575 total), you wouldn’t have any federal income tax liability.  Likewise, for married, filing jointly taxpayers, they can have $24,400 (2019 standard deduction for married, filing jointly taxpayers) of ordinary income and $78,750 of qualified passive income ($103,150 total) to pay zero tax (federal income tax).

If you could find a way to generate that level of income in retirement (early or otherwise), you’d tell Uncle Sam to bugger off because it’s all yours to keep.  You could find qualified dividend-paying investments which yield 2% and live federal income tax-free off of capital investments worth roughly $1,286,000 if you’re single or $2,573,000 if you’re married.  For simplicity, let’s say $1.25 million and $2.5 million.

You could also buy qualified solar equipment with your passive income, thereby allowing you to claim the solar energy investment tax credit and lower your tax liability further.

Of course, you could also see how to pay zero tax and avoid federal income tax liability on some higher-earning qualified dividend investments on less capital investment.  For example, a 5% qualified dividend investment would earn you the max free of federal income tax liability on $772,000 or $1,544,000 worth of capital investments for individuals and couples filing jointly, respectively. This could also come from selling assets held for longer than a year and realizing long-term capital gains.

If you want more federal income tax-free income, you could buy municipal bonds from your state and pay no income taxes.  However, the lower risk profile of these investments often allow for lower interest payments compared to their corporate bond counterparts.  Therefore, these tax-advantaged debt instruments typically reside in higher-income taxpayers as a means for receiving a tax shield on their investment income.

If you did earn ordinary income above the standard deduction and hold real estate, you’ve got more options available to you.  This real estate investment might produce losses you could use to offset your ordinary income earned above the standard deduction if you qualify for the Mom and Pop exception above.

But the real advantage of lower long-term capital gains tax rates is if you end up generating more qualified passive income or long-term capital gains, the first $39,375 or $78,750 in gains are tax-free depending on your filing status and income level.

If you earn between $78,751 and $488,850 as a married, filing jointly taxpayer, you only pay 15% on passive income.  Because of this, to the extent you can manage, you should consider generating as much qualified passive income as you can until you find your optimal level of financial independence.

Looking for Investing Options to Build Passive Income?

Now that you understand the tax advantages of qualified passive income, how do you act on the information?  Well, if you feel conviction in pursuing a strategy of paying Uncle Sam less on your tax-advantaged passive income, the next step is identifying the assets which will produce the best return on your investment.

In addition to those crowdsourced real estate platforms mentioned above (e.g., FundRise, YieldStreet, RealtyMogul), the two best retail brokerages I’ve found for individual stock trading are Robinhood and Webull.

Both offer commission free trading, have real-time market data, and allow you access to thousands of securities which provide qualified passive income like that discussed above.  And for the time being, Webull offers a free share of stock for opening an account on their trading platform as an extra incentive to get started.

webull

These investment services are great for finding those dividend-paying investments best-suited to your needs.  They can help you purchase the best dividend-paying stocks, providing you tax-advantaged passive income.

About the Author and Blog

In 2018, I was winding down a stint in investor relations and found myself newly equipped with a CPA, added insight on how investors behave in markets, and a load of free time.  My job routinely required extended work hours, complex assignments, and tight deadlines.  Seeking to maintain my momentum, I wanted to chase something ambitious.

I chose to start this financial independence and entrepreneurship blog as my next step, recognizing both the challenge and opportunity.  I launched the site with encouragement from my wife as a means to lay out our financial independence journey to reach a Millennial retirement and connect with and help others who share the same goal.

Disclaimer

I have not been compensated by any of the companies listed in this post at the time of this writing.  Any recommendations made by me are my own.  Should you choose to act on them, please see my the disclaimer on my About Young and the Invested page.

Interested in Financial Independence & Entrepreneurship?

Start here with useful resources delivered direct to your inbox.

Join the discussion 13 Comments

  • SmallIvy says:

    Great post and a great topic. As far as long term versus short term capital gains go, however, whether you invest for a year or a second really doesn’t matter to the company, business expansion, job creation, and so on. This is because the company makes its money during the initial public offering and subsequent stock offerings (and it sometime uses the market to pay executives through stock incentive programs). After that point, people are just trading among each other, so whether I hold shares for ten years or ten seconds really doesn’t matter. Now, because short term trends are unpredictable, but long-term trends are somewhat predictable, it is better for the investor to hold a year or longer (or a decade or longer) for his/her own sake.

    Maybe the tax law is designed to encourage people to invest long-term since that is good for them. More likely, however, is that people wanted to reward investing, which is considered noble unless you are too good at it, but not trading, which is just considered greedy. Unfortunately, while taxes should just be there to raise money to pay for government functions like defense and roads, they are used to reward behavior considered noble and punish behavior considered evil.

  • I see the point you’re making. I’d always heard the reasoning as what I wrote in the post. Once the capital has been raised (through an IPO or a secondary offering) the company is indifferent as to the holding patterns of the capital by investors. I think your point is valid about the short term and long-term trends being divergent (former less predictable, and closer to random and the latter more predictable). I also think your next point about the tax law being designed to encourage people to invest for the long-term plays a part.

    But as you suggest, the tax code does want to reward people for making investments over the long-term. I will revise the post to reflect your comment. Thanks for providing your thought-out comment. It has improved the usefulness and accuracy of this post.

  • Xrayvsn says:

    I’m a huge fan of passive income, it is my favorite type of money I earn and preferential tax treatment is one of the big reasons why.

    My income basically triggers the maximum tax bracket for both passive and active income sources but still has a tax arbitrage of 37-23.8% (13.2%)

    • Take any advantage you can get. Passive income is great for building your net worth and reaching financial independence. I’m researching the rationale for the differential in long term and short term capital gains and plan to add that to the post.

  • Ben says:

    I’m a “limited partner” (made an initial investment, but have not since participated) in a few start-up businesses and real estate syndicates that cash flow, and thought this “passive income” “passed through” to my 1040 and was therefore taxed at standard income tax rates. Where in our tax law does does the IRS state/confirm/validate that – as you write above – “passive income” receives the same treatment as long-term capital gains? This would be huge, if true, and significantly minimize my tax exposure. I’m skeptical (seems to good to be true), but intrigued and hopeful. Thanks for the post.

  • Ben says:

    I’ve read through the above link (thank you) – I definitely don’t materially participate, which should qualify the income as “passive”. But where is it stated that this passive income is actually taxed like long term cap gains? That’s the piece I’m missing. Thanks for the quick reply! Grateful again for the post.

  • Fat Tony says:

    I’ve found no information on “passive income” always being long-term capital gains. Passive income can be either taxed at ordinary rates or long-term capital gains rates, and only certain items such as appreciated property sold after a 1-year holding period, or qualified dividends, can be taxed at the long-term rate.

    “The biggest distinction you need to know is that passive forms of income are generally taxed in the same way as ordinary income, not as qualified dividends. However, as we’ll discuss in the next section, there’s a big tax break that may be available if you have passive income.”

    https://www.fool.com/taxes/2018/09/21/the-3-types-of-income-and-how-theyre-taxed.aspx

    Indeed, I still see all of my passively held real estate income being taxed at the ordinary income rate by the IRS. The most one could do is put this through a 199A pass-through to get the 20% exemption there.

    • Tony, you are absolutely correct. I made a mistake classifying rental income as passive income free from federal tax in that section of the post. It is a passive activity which has income taxed at ordinary capital rates.

      In my examples provided at the end, I made a point only to include qualified dividends, long-term capital gains, and municipal bond income as my sources of ordinary federal tax-free income. I mistakenly labeled rental income as passive income free from federal tax earlier in the post.

      I have corrected the article to reflect these changes and I thank you for pointing them out.

  • GenX FIRE says:

    Incredibly thorough and helpful as always. I truly love your posts as I learn something every time I read them. The long term capitol gains bit has me reconsidering some of my models.

    The other thing this proves is the value of a tax professional. I see a lot of hours here that will need to be spent to get up to speed or finding a tax professional that I trust.

    • Taxes affect everything and are an important consideration for reaching financial independence. As I build more wealth and begin transitioning toward developing passive income streams, I’ll be keenly interested to learn and implement these tax-advantaged investing strategies.

      Thanks for reading!

  • katherine says:

    Thanks for the article and your experience. For beginners, this is very useful. When I opened my business, I used the tips

Leave a Reply