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23 Mar 2023

Ordinary vs. Passive Income

Ordinary Income 

The term “ordinary income” can be confusing, as it might suggest that the income is common or normal. However, in the context of tax law, it has a specific meaning. It refers to income earned through the normal course of business operations or from other sources that are not considered investments. Ordinary income includes wages or salaries earned from employment, income from a business, commissions earned from sales, and fees earned for professional services. This income is subject to federal and state income taxes, as well as other taxes such as Social Security and Medicare taxes.

The term “ordinary income” is used to distinguish this type of income from other types of income that may be taxed differently, such as capital gains or passive income. For example, capital gains are generally taxed at a lower rate than ordinary income, and passive income may be subject to different tax rules and limitations. 

Passive Income 

Passive income is earned from sources where the taxpayer is not materially participating in the activity that generates income. This can include rental income, interest income, dividend income, and certain types of capital gains. Passive income is typically generated from investments or rental properties rather than from active business operations. The taxpayer may have some involvement in the investment or property, but they are not considered to be actively engaged in the day-to-day management or operations.

Passive income is generally subject to different tax rules than ordinary income. For example, passive income may be subject to a lower tax rate, and losses from passive income activities can only offset other passive income rather than ordinary income. 

Ordinary vs. Passive Income Tax Reporting 

When it comes to tax reporting (Americans’ favorite pastime), ordinary income and passive income are being treated differently. Ordinary income is generally subject to self-employment tax and is reported on Schedule C of the individual’s tax return. Passive income is typically reported on Schedule E of the tax return. In addition, losses generated from ordinary income activities can offset other ordinary income, such as salaries or wages, up to a certain limit, which can help to reduce the amount of taxable income. However, losses from passive income activities can only offset other passive income and cannot be used to reduce taxable income from other sources.  

For example, suppose you have a net loss of $5,000 from your rental property (which generates passive income) and a net profit of $10,000 from your consulting business (which generates ordinary income). In that case, the $5,000 loss from the rental property can only be used to offset other passive income and cannot be used to reduce the taxable income from the consulting business. There are also certain limitations on the amount of passive losses that can be used to offset passive income. For example, suppose you have $10,000 passive income from a rental property and $15,000 passive losses from another. In that case, you may only be able to use $10,000 of the losses to offset the passive income, and the remaining $5,000 of losses may be carried toward future tax years. 

It is essential to understand the difference between ordinary and passive income and the rules regarding loss offset when reporting income and losses for tax purposes. The IRS isn’t a very forgiving organization when it comes to making mistakes. The Accuracy-Related Penalty is 20% of the portion of the underpayment of tax. Not to mention the interest on the penalty! So save yourself from the heart and headache of making tax mistakes by consulting with a tax professional. In addition, your tax consultant may be able to maximize your tax benefits.  

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