Within this section, we will examine the federal tax treatment of different income types, foreign securities, and wash sales. How taxes affect your client is extremely important to consider when providing information and recommendations.

Types of Income
U.S. federal tax authorities recognize three types of income:

  • Earned income is just what it sounds like: salary, bonus, perquisites, fees for services and other remuneration for work you perform. Earned income is subject to income tax at a rate proportional to a person's income
  • Investment income consists of interest, dividends, capital gains and gains (or losses) from selling securities or property.

    • A capital gain is the difference between the price at which you bought a security and the price at which it is now. If you haven't sold that security yet, the capital gain is said to be unrealized. Capital gains are not taxed until they are realized - that is to say, when you sell them. At that point, they become gains from selling securities and are generally taxed at a lower rate than other income.
    • Cash dividends are payable in the year paid and shareholders must pay tax on the full amount, even if they are reinvested.
      • On the other hand, companies who own stock in other companies will typically qualify for a corporate dividend exclusion of 70% (if they own less than 20% stock in the other company), or 80% (if they own more than 20% of the other company).
    • Stock dividends are not taxable until a capital gain on those securities is realized by selling the securities. At this point, the investor must adjust the cost basis of his or her position to reflect the stock dividend. As a result, capital gains (and its respective tax) will be higher due to the lower cost basis.

  • Passive income is income generated from business activities in which you do not participate materially during the year, such as rental activities (as long as you are not a real estate professional), partnerships (if you are not one of the operating partners), and residuals.
    • Residuals is best explained through the following examples:
      • A sales rep who gets a commission every time an old customer makes a new purchase.
      • A land owner who has hired a professional farmer to run the property
      • A former songwriter who makes a royalty every time his golden oldie is played on the radio (if he were still writing songs professionally, this would not be an example of passive income).

This type of income is treated similarly to earned income except that the tax code recognizes that - unlike earned income - there is the possibility of loss if the partnership or the rental property or the farm is wiped out. However, there is also a recognition that sometimes such losses occur on purpose so the holders of these properties can take a loss and avoid paying taxes. There is an entire unit of the IRS code, Section 469, which prescribes how to account for the risks and losses associated with passive income.



Tax Considerations

Related Articles
  1. Personal Finance

    All About Income

    Income is the money you or a business earns by providing goods or services, or through investments.
  2. Financial Advisor

    The Basics of Income Tax on Mutual Funds

    Learn about the basics of income tax on mutual funds, including what types of income may be subject to the capital gains tax rate.
  3. Taxes

    Explaining Double Taxation

    Double taxation refers to income taxes being imposed twice on the same source of earned income.
  4. Taxes

    Smart Year-End Tax Moves for 2016 (Part Two)

    Here's are some crucial tax planning strategies for investments, Social Security and Medicare.
  5. Small Business

    What is Passive Income?

    Passive income is earned by someone from ventures in which they did not actively participate.
  6. Taxes

    3 Tax Implications of Dividend Stocks

    Dividend paying companies are attractive in a low interest rate environment, but income seeking investors have to be careful of the potential tax hit.
  7. Taxes

    Capital Gains Tax 101

    Find out how taxes are applied to your investment returns and how you can reduce your tax burden.
  8. Retirement

    6 Places To Retire For Low Income Taxes

    These states offer unique tax benefits for their long-term citizens.
  9. Investing

    How Tax-Efficient Is Your Mutual Fund?

    Learn about factors that influence the tax-efficiency of your mutual fund, how income from your investment is taxed and what to look for when choosing a fund.
  10. Taxes

    How Are Capital Gains And Dividends Taxed Differently?

    Individuals in the 25% or higher tax bracket pay a 20% tax on long-term capital gains.
Frequently Asked Questions
  1. What are the Differences Among a Real Estate Agent, a broker and a Realtor?

    Learn how agents, realtors, and brokers are often considered the same, but in reality, these real estate positions have different ...
  2. What is the difference between amortization and depreciation?

    Because very few assets last forever, one of the main principles of accrual accounting requires that an asset's cost be proportionally ...
  3. Which is better, a fixed or variable rate loan?

    A variable interest rate loan is a loan in which the interest rate charged on the outstanding balance varies as market interest ...
  4. What is the 1003 mortgage application form?

    Learn about the 1003 mortgage application form, what information it requires and why this form is the industry standard for ...
Trading Center