What Is Considered Investment Income?

Investment income is money earned from financial assets rather than wages or business operations. It plays a key role in wealth building and is subject to different tax treatments depending on the type and how it is received. Understanding what qualifies as investment income helps with financial planning, tax efficiency, and maximizing returns.

Dividends

Dividends are payments companies make to shareholders from their profits. Publicly traded corporations and some private companies issue these payments regularly, typically quarterly. The amount received depends on the number of shares owned and the dividend per share declared by the company’s board of directors. Some industries, such as utilities and consumer staples, have companies with long histories of paying and increasing dividends.

There are two types of dividends: qualified and non-qualified. Qualified dividends benefit from lower tax rates, ranging from 0% to 20% in 2024, depending on taxable income. To qualify, the stock must be held for more than 60 days during the 121-day period surrounding the ex-dividend date. Non-qualified dividends are taxed as ordinary income, with rates as high as 37% for top earners. Holding stocks for the required period can reduce tax liability.

Some investors reinvest dividends through Dividend Reinvestment Plans (DRIPs), which automatically purchase additional shares instead of issuing cash payments. This strategy compounds returns over time, especially in companies with strong dividend growth. Many blue-chip stocks, such as those in the S&P 500 Dividend Aristocrats index, have a track record of increasing payouts annually, making them attractive for long-term investors.

Interest

Interest income comes from lending money or depositing funds into interest-bearing accounts. Banks and credit unions pay interest on savings accounts, certificates of deposit (CDs), and money market accounts. Bonds, issued by governments and corporations, provide periodic coupon payments. These earnings are taxed as ordinary income at federal and sometimes state levels, based on an individual’s marginal tax rate.

Different types of interest income receive different tax treatments. Interest from municipal bonds is often exempt from federal taxes and, in some cases, state taxes if the investor resides in the issuing state. Treasury bond interest is subject to federal tax but exempt from state and local taxes. High-yield savings accounts and online banks offer competitive interest rates, particularly in a rising rate environment, allowing individuals to earn passive income with minimal risk.

Certain financial products offer deferred interest accumulation. U.S. savings bonds, such as Series I and Series EE bonds, do not pay periodic interest but instead accrue value over time. The interest earned is only taxed when the bond is redeemed, providing a tax-deferral advantage. Some investors use these bonds for education savings since interest may be tax-free if used for qualified educational expenses.

Capital Gains

When an asset is sold for more than its purchase price, the profit is considered a capital gain. This applies to stocks, real estate, collectibles, and cryptocurrency. The tax treatment depends on how long the asset was held before being sold. Assets held for over a year qualify for long-term capital gains tax rates, which range from 0% to 20% in 2024. Short-term gains, from assets sold within a year, are taxed at ordinary income tax rates, which can be as high as 37%.

The cost basis of an asset determines taxable gains. This includes the original purchase price and associated costs like brokerage fees or property improvements. Adjusting for stock splits, reinvested dividends, and return of capital distributions ensures accurate reporting. Investors can use tax-loss harvesting to offset taxable gains by selling underperforming investments. However, the IRS wash-sale rule prevents repurchasing the same or substantially identical security within 30 days before or after the sale if the loss is claimed for tax purposes.

Certain assets receive special tax treatment. Profits from selling a primary residence may qualify for an exclusion—up to $250,000 for individuals and $500,000 for married couples filing jointly—if the owner lived in the home for at least two of the last five years. Collectibles, such as art and precious metals, are subject to a higher maximum capital gains tax rate of 28%. Cryptocurrency transactions must be reported, and each trade or sale is treated as a taxable event, requiring careful record-keeping.

Rental Income

Earnings from leasing residential, commercial, or industrial property count as rental income and must be reported in the year received. This includes monthly rent payments, advance rent, security deposits that are not returned, and tenant-paid expenses that are not reimbursed. Most individual landlords use the cash method of accounting, recording income when received rather than when earned.

Depreciation is a major tax advantage for rental property owners, allowing them to deduct a portion of the building’s cost over 27.5 years for residential properties and 39 years for commercial properties. This non-cash expense reduces taxable income without affecting cash flow. Repairs, such as fixing a broken water heater or repainting walls, are deductible in the year incurred, while improvements that increase the property’s value or lifespan, like adding a new roof, must be capitalized and depreciated. Section 179 and bonus depreciation provisions may allow for accelerated deductions on certain qualifying expenses.

Royalties

Royalties are payments received for allowing others to use intellectual property, such as patents, copyrights, trademarks, or natural resources. These earnings are typically structured as a percentage of revenue generated from the asset’s use. The tax treatment depends on whether they are classified as ordinary income or capital gains, with self-created intellectual property generally taxed at regular income rates.

For authors, musicians, and artists, royalties come from book sales, music streaming, or licensing deals. Publishing contracts specify royalty rates, which can range from 10% to 25% of sales, depending on the medium and distribution method. Advances paid to authors or musicians are deducted from future earnings before additional payments are made. Inventors may license patents to companies in exchange for a percentage of sales, often structured as a fixed royalty per unit sold or a percentage of gross revenue.

Oil, gas, and mineral rights also generate royalties, with landowners receiving a share of production revenue from energy companies extracting resources from their property. These agreements usually involve a lease where the owner retains land ownership but grants extraction rights in exchange for ongoing payments. Typical royalty rates for oil and gas leases range from 12.5% to 25% of production revenue. Unlike intellectual property, depletion deductions may apply to resource-based royalties, reducing taxable income.

Partnership or Business Distributions

Investment income can also come from ownership stakes in partnerships, limited liability companies (LLCs), or S corporations, where profits are distributed to members based on their ownership percentage. These distributions differ from wages or salaries because they represent a share of business earnings rather than compensation for services. The tax implications depend on the entity’s structure, with pass-through taxation applying to most partnerships and LLCs, meaning income is reported on the individual owner’s tax return.

Limited partners typically receive passive income from their investment without actively participating in management, while general partners may be subject to self-employment tax on their share of earnings. S corporation shareholders receive distributions that are not subject to self-employment tax, making this structure attractive for small business owners looking to minimize payroll taxes. However, the IRS requires S corporation owners who actively work in the business to pay themselves a reasonable salary before taking distributions.

Master limited partnerships (MLPs), particularly in the energy and infrastructure sectors, also generate distributions. MLPs pass income, deductions, and depreciation directly to investors, often resulting in tax-deferred distributions. A portion of these payments is classified as a return of capital, reducing the investor’s cost basis rather than being taxed immediately. When the asset is eventually sold, the lower cost basis results in a larger capital gain, making tax planning important for MLP investors.