Is Passive Income Taxable?

Passive income is increasingly becoming popular, with investors looking to diversify their portfolios outside the conventional avenues. As the name suggests, passive income refers to gains from an investment or venture that doesn’t require active management or involvement. Contrary to passive income, active income requires your time, attention and active participation to earn returns.

Earnings from real estate properties in the form of rental yield, rental income from leased-out machinery, interest income from peer-to-peer loans, etc., are all examples of passive income avenues.

Now that more and more investors are looking to explore passive income avenues, it is imperative to learn the technicalities of such options. In this post, we will look at the taxability of passive income in India. We’ll start by looking at what passive income entails, the types of passive income, and their taxability. We will look at the taxation heads under the Income Tax Act of 1961 that provide for the taxation of different sources of passive income.

What is Passive Income?

As stated in the introduction, passive income refers to earnings from sources that do not need active management or involvement. Interest income, for instance, is considered a passive income. Similarly, dividend income from stocks is also considered as passive income.

The idea behind passive income is to earn a substantial income on a regular basis without having to invest your time and energy actively. A regular flow of passive income can be a good way to attain financial freedom where you don’t need to work actively to sustain your current lifestyle.

There are several ways to earn a regular income. 

In the next section, let’s look at a few of the most popular passive income ideas available to investors in India.

Types of Passive Income

Ideally, every instrument that offers a regular fixed income and doesn’t demand active day-to-day management can be considered a passive income. To understand this better, let’s consider the following examples of passive income.

🔵 Real Estate

Real estate, be it commercial or residential real estate, is a popular way of earning a passive income. Real estate offers dual benefits- long-term asset appreciation and regular fixed rental income.

While income from selling a real estate property can be considered a capital gain and an earning that requires active involvement for a sale transaction, rental income from the property is an ideal example of passive income.

Commercial real estate is known to be a lucrative passive income investment that offers higher rental income than residential real estate.

Real estate investments can be made via different avenues; you can either purchase the entire property, acquire fractional ownership, or invest through instruments like REITs or Real Estate Investment Trusts.

🔵 Interest Income

Interest income from your bank FDs or from peer-to-peer lending would also be considered passive income. Considering that such interest incomes are usually in the nature of fixed, regular earnings, they are an ideal example of passive income.

🔵 Dividend income

Dividend income is very similar to interest income in terms of their regular payments. However, dividend income is not always “fixed”, considering that they may differ according to the company’s dividend policy and payout ratio.

Dividend income can be received by investing in stocks of dividend-paying companies, as well as in mutual funds having high dividend yields. Additionally, REITs also offer dividend income to investors.

Now, let’s understand the taxability of passive income in India.

Before you start creating passive income stream for yourself, it is vital that you understand why you should even consider generating passive income. In our blog Importance of Passive Income | Reasons why you should generate passive income stream, you will find all the reasons to generate passive income. 

Taxability of Passive Income in India

Is passive income taxable in India?

A short and simple answer to this question would be a straight Yes!

Passive income is taxable in India under various heads of the Income Tax Act of 1961. As an investor, you should be aware of the taxability of different sources of passive income so as to optimise your investments to make the most returns while reducing your tax burden as much as possible.

To understand the taxability of passive income in India, you need to look at the taxability of various sources of passive income individually. As such, there is no separate provision under the Income Tax Act 1961 that covers the taxability of all different types of passive income.

Different sources of income are considered differently for their tax implication under the Income Tax Act 1961, and accordingly, different heads of income are applicable for different sources. This usually depends on the type and nature of income. Additionally, different heads have different deductions available so as to reduce the overall taxable income of the individual and to encourage investments.

Taxability of Passive Income from Real Estate Investments

Income generated by the transfer or sale of real estate properties is taxed under the “Income from Capital Gains” head under the Income Tax Act of 1961. Considering sale or transfer as an active involvement, ideally, this would not be considered as a passive income.

However, real estate offers multiple avenues of passive income as well. These include rental income, interest income on real estate crowdfunding and dividend income from REITs.

Rental income from let-out house properties is taxed under the head of “Income from House Properties”, provided for in Part C of Chapter IV of the Income Tax Act, 1961. Notably, Section 24 of the Income Tax Act provides for the deductions one can avail to reduce the taxable income from house property. Additionally, deductions provided for under Chapter VI-A in the computation of the total taxable income also need to be accounted for.

Interest income on real estate crowdfunding is also considered as a passive income and is taxed under the head of “Income from other sources” and will be taxed similarly to how interest income from fixed deposits is taxed. Dividends received from REITs or Real Estate Investment Trusts are also taxable under the same head of “Income from other sources” provided for in Section 56 of the Income Tax Act, 1961.

Taxability of Dividend and Interest Income

Dividend income is also taxable under the Income Tax Act of 1961, under the head of “Income from other sources”. Similarly, income received as interest on compensation or enhanced compensation is also taxable under Section 56 of the Income Tax Act in a similar manner as dividend income. Section 57 provides for certain deductions allowed to reduce the taxable income under the head of “Income from other sources”.

Tax on P2P Lending

P2P lending or peer-to-peer lending is becoming an increasingly popular fixed-income investment, and many average investors are now considering it as a stream of passive income and as a good option for diversification from the conventional asset classes.

Is P2P lending taxable? 

Yes, P2P lending income is taxable under the Income Tax Act 1961.

The fixed interest received at regular intervals on your principal amount is similar to interest received on fixed deposits or any other interest-paying instruments. It is hence taxable under the head of “Income from other sources”, i.e. Section 56 of the Income Tax Act, 1961. Again, just like for dividend and interest income, deductions under Section 57 are applicable to interest received from P2P lending investments.

Your overall taxable income is calculated after the computation of income under all the five heads of income provided for in the Income Tax Act 1961; subsequently, you can be eligible for certain deductions in order to reduce your overall taxable income. Once the total taxable income is obtained after all the applicable deductions are made, the taxability will be determined as per the applicable slab rates.