Do You Get Taxed on Passive Income?

The United States tax system requires individuals to report all income unless specifically exempted by law. Among various income categories, passive income holds a distinct position due to its unique tax treatment and specific regulations. Understanding how passive income is defined and taxed is crucial for taxpayers to comply with federal tax laws and manage their financial obligations.

Understanding Passive Income

Passive income is defined by the Internal Revenue Service (IRS) as earnings from a trade or business activity in which the taxpayer does not materially participate, or from rental activities. Common examples include earnings from limited partnerships and most rental real estate activities.

Active income, such as wages and salaries, results from direct involvement. Portfolio income includes interest, dividends, and capital gains from investments like stocks and bonds. The IRS categorizes these income types differently, leading to varied tax implications, particularly regarding the deductibility of losses.

How Passive Income Is Taxed Generally

Passive income is included in a taxpayer’s gross income. The specific tax rate applied depends on its source and nature, potentially falling under ordinary income tax rates or capital gains rates. For instance, rental income is often taxed at ordinary income rates, which correspond to a taxpayer’s marginal tax bracket.

There is no distinct “passive income tax” rate; instead, passive income integrates into the overall federal income tax system. If passive income arises from the sale of an asset held for more than one year, it may be subject to lower long-term capital gains tax rates. Tax treatment can be influenced by specific deductions or additional taxes.

Specific Tax Regulations for Passive Income

The taxation of passive income is governed by specific regulations, primarily the Passive Activity Loss (PAL) rules, which limit the ability to deduct losses from passive activities. Under these rules, passive losses can only offset passive income. If losses exceed income in a given year, the excess is carried forward to future tax years, where they can offset future passive income or be fully deducted upon the taxable disposition of the entire activity. IRS Form 8582 is used to determine deductible passive activity losses.

Material participation can reclassify income or loss from an activity as non-passive. The IRS outlines seven tests to determine if a taxpayer materially participates, meaning their involvement is regular, continuous, and substantial. Meeting just one test is sufficient. These tests include specific hour thresholds, such as participating for more than 500 hours, or if the individual’s participation constitutes substantially all of the activity. Other tests consider participation relative to others, or if the activity is a significant participation activity. Material participation can also be established based on prior year participation or a facts and circumstances test.

Rental real estate activities are generally classified as passive activities by default, even with material participation. An exception exists for “real estate professionals.” To qualify, a taxpayer must meet specific criteria, including performing more than half of their personal services in real property trades or businesses and performing over 750 hours of service in those businesses. If these conditions are met, rental real estate activities are not automatically passive, allowing losses to potentially offset non-passive income.

There is also a special allowance for active participants in rental real estate activities, permitting them to deduct up to $25,000 of passive losses against non-passive income. This allowance begins to phase out when the taxpayer’s modified adjusted gross income (MAGI) exceeds $100,000, and it is completely eliminated once MAGI reaches $150,000. This active participation is a less stringent standard than material participation, typically involving making management decisions or arranging for others to provide services.

Certain passive income, along with other investment income, may be subject to the 3.8% Net Investment Income Tax (NIIT). This tax applies to individuals, estates, and trusts with modified adjusted gross income above specific thresholds. For single filers, the threshold is $200,000, while for those married filing jointly, it is $250,000. The NIIT is levied on the lesser of a taxpayer’s net investment income or the amount by which their MAGI exceeds the applicable threshold. Net investment income includes interest, dividends, capital gains, rental and royalty income, and passive business income.

Self-employment tax generally does not apply to passive income, such as most rental income. This tax primarily covers Social Security and Medicare taxes for individuals who work for themselves. However, income from certain entities, like an LLC, where the taxpayer materially participates, could be subject to self-employment tax, even if the entity structure might otherwise suggest passive income. This highlights the importance of understanding the level of involvement in an activity when determining tax obligations.