These days and the struggling and staggering economy, we can no longer only rely on one stream of income. Passive income buzzword has become a popular solution for many but, what is passive income and how does it work with your tax obligations?
We’ll explore the tax on passive income with a focus on rental income and how it impacts your financial planning.
Definitions: Passive Income
Passive income is defined as income from a source that does not require much effort unlike working a 9 to 5 and receiving a monthly salary that is loosely based on your daily efforts. Passive income can basically be anything that generates an extra income other than your monthly salary like returns on investments, property rentals, digital workings/products, etc.
Now when we only look at the positive side of having extra income, it all seems glorious in the sense of things, but unfortunately, we have to place this in a TAX angle…
Active vs Passive
Tax is quite a complex, law driven concept spanning over many branches of todays life, but for now lets’ keep it simple by using the rental of property and the tax effects it has in a passive income scenario.
Let us first get an understanding of normal tax on our salary. Your employer calculates and deducts PAYE on your salary every month. The PAYE is calculated by assuming your salary is your only income for the year and is deducted to be exactly enough according to SARS.
Mr. Van Wyk, Accountant and Tax Practitioner at CTV & Associates, describes this principle as follows:
“If you look at this picture…all the eggs in the basket are your yearly salary and the two eggs placed outside of the basket, that is your tax that was deducted to be perfectly enough for the amount of eggs in the basket.“
You are now also earning rental income from the letting of fixed property. When you are earning rental income you will earn a monthly rental income, before any other expenses are disbursed. There are certain expenses that we can deduct from the gross rental income such as agent commission, electricity, finance on the bond and other expenses, depending on your specific scenario. This whole exercise will give you a yearly net profit (gross income minus applicable expenses) that must now be included in your total yearly income. Your total yearly income will now consist of your yearly salary as well as the net rental profit.
Let us now compare that to the previous image of the eggs in the basket:
As we now can clearly see that the amount of eggs in the basket (income) has increased significantly, but the eggs outside of the basket (PAYE tax) has still remained the same. This is a common misconception that all new passive earning taxpayers’ encounter.
We, as taxpayers, are taxed on a cumulative yearly basis taking into account all of our income for that specific year. When earning any passive income, you must keep in mind that the income received is usually before any tax has been calculated and taken out of the basket.
This can cause some major and sudden cashflow problems when it comes down to submitting your yearly taxes. When this applies to you and your journey of building wealth, call us, ask us and we will CTV your query in the given scenario.
GET IN TOUCH
