What Unearned Income Is and How It Is Taxed
Published on August 27, 2024
by Jeff Patterson
Jeff Patterson is an American living in Scotland and joined the team at Expat Tax Online after experiencing the complexities of living abroad with a family.
Table of Contents
What is unearned income?
Unearned income is income that you receive without actively working for it.
Unlike wages or salaries, which you earn by providing services or labor, unearned income comes from other sources, such as:
- Interest: Money earned from savings accounts, bonds, or certificates of deposit (CDs).
- Dividends: Payments made to shareholders from a corporation’s profits.
- Rental Income: Income earned from renting out property.
- Capital Gains: Profits from selling assets like stocks, real estate, or other investments.
- Royalties: Payments received from intellectual property like patents, books, or music.
So, in general, earned income includes wages, salaries, tips, and other compensation received from employment. Unearned income, on the other hand, does not require active work.
How is unearned income taxed?
Unearned income is taxed at different rates, and the taxation method can vary based on the type of income.
- Interest Income: Typically taxed as ordinary income, meaning it is subject to your regular income tax rates.
- Dividends: Qualified dividends are taxed at the lower capital gains tax rates, while non-qualified dividends are taxed at ordinary income tax rates.
- Rental Income: This income is generally taxed as ordinary income, but you can deduct certain expenses, like mortgage interest, property taxes, and maintenance.
- Capital Gains: The tax rate on capital gains depends on how long you’ve held the asset. Short-term capital gains (for assets held for one year or less) are taxed as ordinary income. Long-term capital gains (for assets held for more than a year) are taxed at reduced rates—typically 0%, 15%, or 20%, depending on your income level.
What else should I know about unearned income?
The addition of unearned income can affect your eligibility for various tax credits and deductions.
For instance, tax credits like the Earned Income Tax Credit (EITC) have income limits, and unearned income could cause you to exceed those limits, reducing or eliminating your eligibility.
Similarly, higher levels of unearned income can also limit your ability to take deductions, such as those for medical expenses or charitable contributions, by increasing your adjusted gross income (AGI).
There’s also the Net Investment Income Tax (NIIT)
The Net Investment Income Tax (NIIT) is an additional 3.8% tax on certain types of unearned income, such as dividends, interest, and capital gains, for individuals whose modified adjusted gross income (MAGI) exceeds US$200,000 (or US$250,000 for married couples filing jointly).
Why use the IRS Streamlined Tax Amnesty Program?
It’s for American citizens that didn’t know they had to file U.S. tax returns each year, and have therefore fallen behind. Some more than 30 years! With the IRS Streamlined Procedure, say goodbye to overdue tax returns, late fees, and penalties.
Connect with over 10,000+ expats today!
Embarking on an international journey shouldn’t mean navigating the complex world of US taxation alone. If you’re living and working abroad, our friendly, supportive Expat Tax Online Help Facebook group is here to assist. We’ve designed a community that serves as a comprehensive guide and resource platform tailored for US expats.
How does unearned income affect tax obligations for US expats?
As a US expat, you are still required to report unearned income on your US tax return, even if that income is earned from foreign sources.
This includes income from investments, rental properties, and other passive income sources. Failing to report this income can result in penalties and interest charges from the IRS.
Can I use Foreign Tax Credits (FTC) for taxes paid on unearned income?
Yes. If you’ve paid taxes on your unearned income to a foreign government, you may be eligible for the Foreign Tax Credit.
How are capital gains from investments taxed?
Capital gains from investments are taxed based on how long you held the asset before selling it.
If you held the asset for one year or less, the gain is considered a short-term capital gain and is taxed at your ordinary income tax rate.
However, if you held the asset for more than one year, the gain is a long-term capital gain and is taxed at a lower rate, typically 0%, 15%, or 20%, depending on your total taxable income.
Are there any tax benefits for unearned income if I am retired?
Yes, retirees may receive certain tax benefits related to unearned income, depending on the type of income and your overall financial situation.
For example, Social Security benefits, which count as unearned income, may not be fully taxable depending on your total income.
How does rental income get taxed if I own property abroad?
Rental income from property owned abroad is taxed similarly to rental income from US-based property.
You are required to report this income on your US tax return, regardless of where the property is located. The income is generally taxed as ordinary income, meaning it will be subject to your regular income tax rates.
However, you can deduct certain expenses related to the property, such as mortgage interest, property taxes, insurance, and maintenance costs, which can reduce your taxable rental income.
Additionally, if you pay foreign taxes on the rental income, you may be eligible for certain tax offsets, such as the FTC or FEIE.
Spread the word. Please share… 👉
