Do You Have to Pay Taxes on Passive Income?

Do You Have to Pay Taxes on Passive Income?

Many people envision passive income as money earned with minimal ongoing effort, often implying it might be free from tax obligations. This perception does not align with tax realities. While passive income can reduce the need for active work, it is subject to federal income taxes. Understanding how different types of passive income are classified and taxed is important for financial planning.

Defining Passive Income for Tax Purposes

For U.S. tax purposes, passive income has a specific definition. The Internal Revenue Service (IRS) defines passive income as earnings from a trade or business in which the taxpayer does not materially participate. This also includes income from all rental activities, unless specific exceptions apply.

This tax definition distinguishes passive income from “earned income” (salaries, wages, business profits with substantial involvement) and “portfolio income” (interest, dividends, capital gains from investments). While often considered “passive,” portfolio income is treated as a distinct category for tax rules.

Common examples of income sources classified as passive activities include rental real estate, where the owner may not be heavily involved in daily management. Interests in limited partnerships are categorized as passive, as the limited partner usually does not participate in the business’s operations. Businesses in which an owner invests but does not actively manage or operate also generate passive income.

How Different Passive Income Sources Are Taxed

Passive income taxation depends on its specific source and IRS classification. Each income type has its own rules regarding what is taxable and at what rate.

Rental income is generally considered passive income and is reported on a gross basis. Taxpayers can deduct various ordinary and necessary expenses incurred in operating the rental property, such as mortgage interest, property taxes, insurance, repairs, and depreciation. The net rental income, after these deductions, is taxed at ordinary income tax rates. If a rental property is sold, any depreciation claimed may be subject to “depreciation recapture,” which taxes a portion of the gain at a higher rate, up to 25%, before capital gains rates apply to the remaining gain.

Interest income received from sources like savings accounts, CDs, and corporate bonds is usually taxable at ordinary income rates. This income is reported on Form 1099-INT. In contrast, interest earned from certain municipal bonds is often exempt from federal income tax, and sometimes from state and local taxes as well, depending on where the bond was issued and the taxpayer resides.

Dividend income is categorized into two main types: ordinary dividends and qualified dividends. Ordinary dividends are taxed at the taxpayer’s regular ordinary income tax rates, similar to wages. Qualified dividends receive preferential tax treatment and are taxed at the lower long-term capital gains rates (0%, 15%, or 20% depending on income). To be considered qualified, dividends must be from a U.S. corporation or a qualifying foreign corporation, and the stock must be held for a specific period.

Capital gains from the sale of investments such as stocks, bonds, or real estate held for investment are subject to tax. Gains from assets held for one year or less are short-term capital gains and are taxed at ordinary income rates. Gains from assets held for more than one year are long-term capital gains, taxed at 0%, 15%, or 20%. The “basis” of an asset (its cost plus any adjustments) is deducted from the sale price to determine the taxable gain or loss.

Royalty income, earned from intellectual property like books or patents, or from natural resources, is taxed at ordinary income rates. This income represents compensation for the use of property or rights and is considered non-passive unless it arises from a trade or business in which the taxpayer does not materially participate.

Understanding Passive Activity Rules and Other Special Taxes

Overarching tax rules significantly impact how passive income is treated. These rules can limit deductions or impose additional taxes.

The Passive Activity Loss (PAL) rules limit the ability to deduct losses from passive activities. Passive losses can only offset passive income; they cannot be used to reduce active income (like wages) or portfolio income (like interest or dividends). Any unused passive losses can be carried forward indefinitely and used to offset passive income in future tax years, or they may be deductible in full when the entire passive activity is disposed of in a taxable transaction.

There are some exceptions to the PAL rules, particularly for rental real estate. A special allowance permits individuals who “actively participate” in rental real estate activities to deduct up to $25,000 of passive rental losses against non-passive income each year. This allowance begins to phase out for taxpayers with modified adjusted gross income (MAGI) above $100,000 and is completely phased out at $150,000. Additionally, a taxpayer who qualifies as a “real estate professional” can treat their rental real estate activities as non-passive, allowing them to deduct losses against any type of income without limitation, provided they materially participate in the activities.

The Net Investment Income Tax (NIIT) is an additional 3.8% tax that applies to certain net investment income for individuals, estates, and trusts with income above specific thresholds. For individuals, these thresholds are $200,000 for single filers and heads of household, and $250,000 for those married filing jointly or qualifying widow(er)s. Net investment income subject to this tax includes interest, dividends, capital gains, rental and royalty income, and income from businesses in which the taxpayer does not materially participate. The NIIT is applied to the lesser of the net investment income or the amount by which the modified adjusted gross income exceeds the applicable threshold.

Tax-advantaged accounts, such as Individual Retirement Arrangements (IRAs) and 401(k)s, offer a different tax treatment for passive income earned within them. Income and gains generated inside these accounts are tax-deferred, meaning taxes are paid only upon withdrawal in retirement. Roth IRAs provide an even greater benefit, as qualified withdrawals in retirement are entirely tax-free, including the growth from passive investments held within the account. These accounts can be effective tools for accumulating wealth from passive income without immediate tax burdens.

Reporting Passive Income on Your Tax Return

Reporting passive income on a federal income tax return involves using specific forms and schedules.

Rental and royalty income, along with income or loss from partnerships and S corporations where the taxpayer does not materially participate, are reported on Schedule E (Supplemental Income and Loss). This schedule allows for the detailed reporting of income and deductible expenses related to these activities. The net income or loss from Schedule E then flows to the main Form 1040.

Capital gains and losses from the sale of investments like stocks, bonds, and real estate are reported on Schedule D (Capital Gains and Losses). This form categorizes gains and losses as either short-term or long-term, which determines their tax rate. Information needed for Schedule D often comes from Form 8949, which details individual sales transactions.

Interest income and ordinary dividend income are commonly reported on Form 1099-INT and Form 1099-DIV, respectively, issued by financial institutions. If the total amounts are above certain thresholds, or if there is foreign tax paid or backup withholding, these amounts may first be summarized on Schedule B (Interest and Ordinary Dividends) before being transferred to Form 1040. Otherwise, they can be directly reported on Form 1040.

Income from pass-through entities like partnerships, S corporations, and some trusts is reported to taxpayers on a Schedule K-1. The information from a Schedule K-1, which can include passive income, capital gains, and other items, is then used to complete the appropriate sections of the taxpayer’s Form 1040, often flowing to Schedule E or Schedule D, depending on the nature of the income.