How Are Passive Income Tax Rates Calculated?
Calculating tax on passive income involves several layers. See how the source of your earnings and your overall income level determine the final tax treatment.
Passive income represents earnings from an enterprise in which an individual is not materially involved. This can include income from rental properties or a business where you are a silent partner. The tax treatment of this income varies significantly based on the specific type of income generated.
Different streams of passive income are subject to different tax rules and rates. It is not a single, flat tax but a system that requires you to first classify your income correctly. You must then apply the appropriate regulations to determine your tax liability.
Classifying Your Income for Tax Purposes
For federal tax purposes, the Internal Revenue Service (IRS) separates income into three distinct categories. The first is active income, which includes wages, salaries, commissions, and earnings from a business in which you materially participate. Material participation can be defined by working more than 500 hours in the business during the year.
A second category is passive income, which comes from trade or business activities in which you do not materially participate. Common examples include income from rental properties and earnings from a limited partnership where you are not involved in daily operations.
The third category is portfolio income, derived from investments like interest, dividends, royalties, and capital gains. While the IRS considers it a separate category from passive income, its components are often subject to the same tax rates and additional taxes.
Tax Rates on Different Types of Passive Income
The tax rate for passive and portfolio income depends on its nature. Some types are taxed as ordinary income, subject to the same progressive tax brackets as wages. This includes interest, non-qualified dividends, short-term capital gains from assets held for one year or less, and net income from most rental activities.
For 2025, the ordinary income tax brackets range from 10% to 37%. For a single individual, the first $11,925 of taxable income is taxed at 10%, and income from $11,926 to $48,475 is taxed at 12%. The rate increases as income rises. For married couples filing jointly, the 10% bracket applies to the first $23,850 of income, and the 12% bracket applies to income from $23,851 to $96,950.
Other forms of passive and portfolio income receive more favorable tax treatment. Long-term capital gains, from the sale of an asset held for more than one year, are taxed at preferential rates. The same applies to qualified dividends from stocks held for a specified period. For 2025, these rates are 0%, 15%, or 20%, depending on your total taxable income.
The income thresholds for these preferential rates are adjusted for inflation. In 2025, a single filer with a total taxable income of up to $48,350 pays a 0% rate on their long-term capital gains and qualified dividends. The 15% rate applies to those with income up to $533,400, and the 20% rate applies to income above that threshold. For married couples filing jointly, the 0% rate applies up to an income of $96,700, the 15% rate up to $600,050, and the 20% rate for income above that amount.
The Passive Activity Loss Rules
When a passive activity generates a loss, the Passive Activity Loss (PAL) rules apply. These rules were enacted to prevent taxpayers from using losses from passive investments to offset regular earnings. The core principle is that losses from passive activities can only be used to offset income from other passive activities.
For example, if a rental property produced a $10,000 loss and a limited partnership generated $8,000 of passive income, you can use $8,000 of the loss to offset that income. The remaining $2,000 loss cannot be used to reduce your active income, like your salary, or your portfolio income.
An exception exists for rental real estate. Taxpayers who “actively participate” in their rental activities can deduct up to $25,000 of rental losses against non-passive income. Active participation is a less stringent standard than material participation and involves making management decisions like approving tenants. This allowance is phased out for taxpayers with a modified adjusted gross income (MAGI) between $100,000 and $150,000.
Passive losses that cannot be used in the current year are not lost. These unused losses are suspended and carried forward to future tax years to offset future passive income. If you sell your entire interest in the activity, you can then deduct any remaining suspended losses.
Understanding the Net Investment Income Tax
Higher-income individuals with passive and portfolio income may be subject to an additional tax: the Net Investment Income Tax (NIIT). This is a 3.8% surtax, introduced as part of the Affordable Care Act, that is calculated on top of your regular income tax liability. It applies to specific types of investment earnings.
The 3.8% tax is applied to the lesser of your total net investment income or the amount your modified adjusted gross income (MAGI) exceeds certain thresholds. Net investment income includes interest, dividends, capital gains, rental income, and income from passive business activities. It does not apply to wages or distributions from most retirement accounts.
The MAGI thresholds for the NIIT depend on your filing status and are not indexed for inflation. The threshold is $200,000 for single filers, $250,000 for married couples filing jointly, and $125,000 for married couples filing separately. You are not subject to the NIIT if your MAGI is below your applicable threshold.
Reporting Passive Income on Your Tax Return
Reporting passive and portfolio income requires using specific IRS forms, with the information ultimately flowing to your Form 1040 tax return. Common forms for reporting this income include:
- Schedule B, Interest and Ordinary Dividends: Used for interest and dividend income, required if either total exceeds $1,500.
- Schedule D, Capital Gains and Losses: Used to report gains and losses from selling assets and to distinguish between short-term and long-term transactions.
- Schedule E, Supplemental Income and Loss: Used to report income and expenses from activities like rental real estate, royalties, partnerships, and S corporations.
- Form 8960, Net Investment Income Tax: Used to calculate the 3.8% surtax if you are subject to the NIIT.