Like HowStuffWorks on Facebook!

How is residual income taxed?

Reporting Residual Income
Residual income and earned income are taxed just about the same. Losses are a little different, though.
Residual income and earned income are taxed just about the same. Losses are a little different, though.

Residual or passive income is taxed in the same way as earned income. The amount you pay is based on your adjusted gross income and federal tax bracket, in addition to your bracket for state and local taxes, if they apply. You pay income taxes for the year in which the gains are received.

The difference is in the losses. Most taxpayers know that certain tax gains can be offset by tax losses, which limits the amount of tax you owe. You may only offset passive income losses with passive income gains — they can't be interchanged or used against gains from other types of income. If you don't have the passive income, your losses are disallowed and will be carried forward for future use [source: Fishman].

Real estate rules differ slightly, however. Generally, rental income is taxed at ordinary income tax rates. But you may take deductions from rental income for depreciation, repairs and expenses. You can sell a property and move the assets into a new property without taking a tax hit. If a property is sold, the income is taxed at capital gains rates [source: IRS]. And with real estate, there is a way to deduct a portion of passive loss from your active income. It's a special allowance that lets individuals who materially participate in a passive rental activity deduct up to $25,000 lost from a non-passive activity [source: IRS].

How to Report Residual Income

Residual income and other types of income are generally reported on Schedule E. Business income may also be listed on Schedule C, and farming income is listed on Schedule F.

In all cases, passive income will be from a venture in which you don't materially participate. If the income is from the sale of a piece of real estate, it may be listed as a capital gain or capital loss on Schedule D. You might also have to include supporting documentation, like a Share of Income statement, by filing a Schedule K-1 with your federal return.

If you are taking passive losses or credits, you must also file federal tax form 8582. If you are still trying to sort out the difference, the form 8582 worksheet is a great resource for defining passive, active or portfolio income [source: IRS].

More to Explore