Does Passive Income Get Taxed? A Look at the Tax Rules

Passive income is a significant topic for many seeking financial growth beyond traditional employment. While generally subject to taxation in the U.S., how it’s taxed varies by source and individual circumstances. The IRS categorizes income to determine tax implications, and understanding these distinctions is important for accurate reporting. This article explores the IRS’s definition of passive income, how various sources are taxed, the Net Investment Income Tax, and reporting procedures.

Defining Passive Income for Tax Purposes

The IRS defines “passive income” based on the taxpayer’s level of involvement, distinguishing it from active income. It primarily includes trade or business activities where the taxpayer does not materially participate, and most rental activities. Material participation signifies regular, continuous, and substantial involvement; the IRS provides tests where meeting one is sufficient to classify an activity as non-passive. Common passive income sources include rental property income (unless the owner is a real estate professional), limited partnership interests, and royalties from intellectual property not created by the taxpayer.

How Different Passive Income Sources Are Taxed

The taxation of passive income depends on its specific source, with different rules applying to various types of earnings. Most forms of passive income are taxed as ordinary income, similar to wages, but some may qualify for preferential capital gains rates.

Rental Income

Rental income is a common form of passive income, generally taxed as ordinary income. Gross rental income includes all payments received for the use of property, such as regular rent payments, advance rent, and certain fees. Taxable rental income is reduced by allowable expenses, which can include mortgage interest, property taxes, depreciation, repairs, and management fees. While rental activities are typically considered passive, passive activity loss rules may limit the deduction of losses, though an exception exists for real estate professionals who meet specific material participation criteria.

Interest Income

Interest income, derived from sources like savings accounts, certificates of deposit (CDs), corporate bonds, and money market accounts, is typically taxed as ordinary income. This income is generally taxable in the year it is received or made available. An exception exists for interest earned on certain municipal bonds, which may be exempt from federal income tax and sometimes state and local taxes, if issued within the taxpayer’s state of residence.

Dividend Income

Dividend income is taxed differently based on its classification. “Ordinary” (non-qualified) dividends are taxed at ordinary income tax rates, which align with an individual’s marginal tax bracket. “Qualified” dividends, however, are eligible for the lower long-term capital gains rates. To qualify for these preferential rates, dividends must meet specific criteria, including holding period requirements for the underlying stock.

Capital Gains

Capital gains from the sale of investments, such as stocks, mutual funds, or real estate not held for active business, are subject to capital gains tax. The tax rate depends on the holding period of the asset. Short-term capital gains result from selling an asset held for one year or less, and these gains are taxed at ordinary income rates. Long-term capital gains arise from assets held for more than one year and are taxed at preferential rates, which are typically lower than ordinary income rates.

Royalty Income

Royalty income, generated from intellectual property like books, music, or patents, or from natural resources such as oil and gas, is generally taxed as ordinary income. The self-employment tax may also apply if the royalties stem from active business activities. For non-qualified annuity income, only the earnings portion of the payment is taxable, and this is typically treated as ordinary income.

The Net Investment Income Tax

Certain individuals, estates, and trusts may be subject to the Net Investment Income Tax (NIIT), an additional 3.8% tax on certain net investment income. This tax applies if modified adjusted gross income (MAGI) exceeds specific thresholds: $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 for NIIT purposes includes interest, dividends, capital gains, rental and royalty income, non-qualified annuity income, and income from passive business activities. The tax is calculated on the lesser of net investment income or the amount by which MAGI exceeds the applicable threshold. Taxpayers use Form 8960 to calculate this tax.

Reporting Passive Income on Your Tax Return

Accurately reporting passive income on your tax return involves using specific IRS forms that consolidate different income types. The totals from these specialized schedules then flow into your main Form 1040.

Schedule B

Schedule B, Interest and Ordinary Dividends, is used to report taxable interest and ordinary dividend income. You generally need to file Schedule B if your taxable interest or ordinary dividends exceed a certain amount, or if you have a financial interest in a foreign account. Information for this schedule often comes from Form 1099-INT for interest and Form 1099-DIV for dividends.

Schedule D

Schedule D, Capital Gains and Losses, is the form for reporting gains and losses from the sale of capital assets, such as stocks, bonds, and real estate. This schedule is used to calculate whether you owe taxes on gains or can deduct losses. It is used with Form 8949, Sales and Other Dispositions of Capital Assets, which provides detailed transaction information. Source documents like Form 1099-B, Proceeds from Broker and Barter Exchange Transactions, are essential for completing these forms.

Schedule E

Schedule E, Supplemental Income and Loss, is used to report income or loss from rental real estate, royalties, partnerships, S corporations, estates, and trusts. This schedule allows taxpayers to detail income and expenses for each rental property. For income from partnerships or S corporations, taxpayers typically receive a Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., or Shareholder’s Share of Income, Deductions, Credits, etc., which provides the necessary figures for Schedule E.