Is Passive Income Taxable? A Review of Tax Rules

Understanding how passive income is taxed is important for individuals navigating the United States tax system. This type of income, often generated with minimal ongoing effort, has specific rules governing its tax treatment. This article clarifies the general tax implications of passive income within the U.S. framework.

Defining Passive Income

The Internal Revenue Service (IRS) categorizes income into three main types: active, passive, and portfolio. Passive income, for tax purposes, refers to earnings from trade or business activities in which the taxpayer does not materially participate. It also includes all rental activities, even if there is material participation, unless the taxpayer qualifies as a real estate professional.

Common examples of passive income include rental real estate activities where the owner is not actively involved in day-to-day management, and income from limited partnerships or S-corporations where the taxpayer does not materially participate. Royalties from intellectual property, such as a book or song, can also be considered passive income. This differs from active income, like wages or profits from an actively managed business, and portfolio income, which stems from investments like interest, dividends, and capital gains.

General Principles of Taxation

Passive income is generally subject to taxation within the United States. Like other forms of income, it is included when calculating a taxpayer’s adjusted gross income (AGI) and overall tax liability. This income may be subject to federal income tax, and potentially state and local taxes, depending on the jurisdiction where the income is earned.

The rate at which passive income is taxed can vary significantly based on its source and the taxpayer’s overall income level. For instance, ordinary rental income or royalties are generally taxed at ordinary income tax rates, which can range from 10% to 37%. However, certain types of income, such as qualified dividends and long-term capital gains, may benefit from preferential, lower tax rates, ranging from 0% to 20%.

Passive Activity Loss Rules

A significant aspect of passive income taxation involves the passive activity loss (PAL) rules, which limit the deduction of passive losses. Under these rules, losses generated by passive activities can only offset income from other passive activities. For example, a loss from a rental property typically cannot be used to reduce taxable wages or portfolio income.

If passive losses exceed passive income in a given year, the unused losses are suspended and carried forward indefinitely to future tax years. These suspended losses can then be used to offset passive income in subsequent years or are fully deductible when the taxpayer disposes of their entire interest in the passive activity in a taxable transaction. There are exceptions to these rules, such as the “real estate professional” exception, which allows certain individuals to treat rental losses as non-passive, enabling them to offset other income. Additionally, an “active participation” rule for rental real estate allows some taxpayers to deduct up to $25,000 of passive rental losses against non-passive income, though this allowance phases out for modified adjusted gross incomes between $100,000 and $150,000.

Net Investment Income Tax

High-income taxpayers may be subject to an additional tax known as the Net Investment Income Tax (NIIT). This tax, imposed at a rate of 3.8%, applies to certain types of investment income.

The NIIT applies to individuals, estates, and trusts when their modified adjusted gross income (MAGI) exceeds specific thresholds. For 2024, these thresholds are $200,000 for single filers or heads of household, and $250,000 for married couples filing jointly or qualifying surviving spouses. The tax is levied on the lesser of a taxpayer’s net investment income or the amount by which their MAGI surpasses the applicable threshold. Income subject to NIIT includes interest, dividends, capital gains, rental and royalty income, and income from businesses that are passive activities to the taxpayer.

Reporting Passive Income

Accurately reporting passive income on federal income tax returns involves using specific IRS forms. For interest income and ordinary dividends, taxpayers use Schedule B (Form 1040). This form is required if the total interest or ordinary dividends received exceed $1,500 in a tax year.

Capital gains and losses from the sale of investments are reported on Schedule D (Form 1040). This schedule helps calculate the net gain or loss from transactions involving capital assets. Rental and royalty income, along with income from partnerships or S-corporations where the taxpayer does not materially participate, are reported on Schedule E (Form 1040). Schedule E allows for the reporting of both income and associated expenses for these activities.