Can Passive Income Be Taxed? How the Rules Work

Earning income without actively working for it, often termed passive income, is generally subject to taxation. While many believe these earnings are exempt, this is a misconception. The specific tax treatment depends on the income source and an individual’s financial situation.

Defining Passive Income

For tax purposes, passive income differs from active and portfolio income. Active income includes wages, salaries, and earnings from a business with material participation. Portfolio income, in contrast, typically involves interest, dividends, and capital gains from investments. The Internal Revenue Service (IRS) defines a “passive activity” as a trade or business where the taxpayer does not materially participate, or any rental activity, unless the taxpayer qualifies as a real estate professional.

Common passive income examples include earnings from rental properties where the owner does not actively manage, or royalty income from intellectual property if the creator is not actively involved. Income from limited partnerships also falls into this category, as the limited partner does not participate in daily operations. This distinction is important because it dictates how losses from these activities are treated for tax purposes.

General Taxation Principles for Passive Income Sources

Income types like interest, dividends, and capital gains are categorized as portfolio income by the IRS. Interest income is taxed as ordinary income at an individual’s marginal tax rate, including interest from bank accounts, certificates of deposit (CDs), and most bonds. Exceptions exist, such as interest from certain municipal bonds, which may be exempt from federal, state, and local taxes depending on the issuer and residence.

Dividend income is treated differently based on its classification. Qualified dividends receive preferential tax treatment, taxed at lower long-term capital gains rates of 0%, 15%, or 20% depending on income. Non-qualified, or ordinary, dividends are taxed as ordinary income, at rates ranging from 10% to 37%. For a dividend to be qualified, specific criteria must be met, including the dividend being from a U.S. corporation or a qualified foreign corporation, and the stock meeting a minimum holding period.

Capital gains from the sale of investments like stocks or real estate are subject to varying tax rates based on the holding period. Short-term capital gains, derived from assets held for one year or less, are taxed at the same rates as ordinary income. Conversely, long-term capital gains, from assets held for more than one year, qualify for lower tax rates (0%, 15%, or 20%), similar to qualified dividends. This favorable treatment for long-term gains is intended to encourage long-term investment.

Specific Tax Rules for Passive Activities

The IRS has specific rules for “passive activities” that impact how associated losses can be used. The Passive Activity Loss (PAL) rules limit the deduction of losses from passive activities to the amount of income generated from other passive activities. This means a passive loss cannot be used to offset active income, such as wages, or portfolio income like interest and dividends. Disallowed passive losses are carried forward to future tax years. These suspended losses can then be deducted against passive income in future years or fully deducted when the entire passive activity is sold in a taxable transaction.

“Material participation” is key to determining whether an activity is passive. Material participation means involvement in an activity on a regular, continuous, and substantial basis. While the IRS outlines seven specific tests to determine material participation, the core principle revolves around the taxpayer’s significant involvement in the operation of the business. However, rental activities are considered passive regardless of the level of participation, unless a specific exception applies.

One exception to the PAL rules is for qualifying Real Estate Professionals (REP). If an individual meets specific criteria, their rental real estate activities are not automatically considered passive, allowing them to deduct losses against non-passive income. To qualify as a REP, a taxpayer must spend more than half of their personal services in real property trades or businesses in which they materially participate, and perform at least 750 hours of service during the tax year in those same activities. This status can offer substantial tax advantages, including avoiding the 3.8% Net Investment Income Tax on rental profits.

The Net Investment Income Tax (NIIT) is an additional 3.8% tax that applies to certain individuals, estates, and trusts with income above specific thresholds. For individuals, the NIIT applies if modified adjusted gross income (MAGI) exceeds $200,000 for single filers or $250,000 for those married filing jointly. This tax is levied on the lesser of an individual’s net investment income or the amount by which their MAGI exceeds the applicable threshold. Net investment income subject to this tax includes interest, dividends, capital gains, income from rental properties, and royalties, among other passive investment income sources.

Reporting Passive Income

Accurately reporting passive income and related losses on a tax return is a necessary step for compliance. Different types of passive income are reported on various IRS forms. Interest and ordinary dividends are generally reported on Schedule B (Form 1040), titled “Interest and Ordinary Dividends.” This schedule is typically required if an individual receives more than $1,500 in taxable interest or ordinary dividends during the tax year.

Capital gains and losses from the sale of investments are reported on Schedule D (Form 1040), “Capital Gains and Losses.” This form is used to calculate the net gain or loss from these transactions, distinguishing between short-term and long-term capital gains. Income and losses from rental real estate, royalties, partnerships, and S corporations are reported on Schedule E (Form 1040), “Supplemental Income and Loss.” This schedule is where the detailed income and expense figures for these activities are listed. Maintaining precise records of all income, expenses, and any suspended passive losses is important for accurate tax preparation and to support reported figures if questions arise.