Tax preparers must identify passive income and losses and calculate the tax liability. Taxpayers pay less in taxes on certain types of passive income.
Read on to understand the definition of passive income and losses, how gains and losses are calculated, and the current tax rates. Use this information to provide accurate tax advice to your clients.
Passive income is generated from trade or business activities in which the individual doesn’t materially participate. Passive income is also generated from rental activities, even if the taxpayer materially participates in the activity. However, income generated by a real estate professional is not passive.
The taxation of passive income varies depending on the type and how long the asset was held. Some types of passive income are taxed at lower rates than the taxpayer’s marginal tax rate.
Passive activity income includes all income from passive activities and generally includes gains from the disposition of an interest in a passive activity or property used in a passive activity. Here are some common sources of passive income.
Limited partners often invest capital in exchange for a partnership interest. In most cases, limited partners do not materially participate in partnership operations. As a result, the income earned is passive.
Rental activities, including rental real estate activities, are passive activities even if the individual materially participates. However, rental real estate activities in which the taxpayer materially participates aren’t passive activities if the person is a real estate professional.
Self-charged interest income and deductions result from loans between the taxpayer and a partnership or S corporation in which the individual had a direct or indirect ownership interest. This includes both loans made to the partnership or S corporation and loans the partnership or S corporation made to the taxpayer.
Self-charged interest income or deductions may be treated as passive activity income or passive activity deductions if the loan proceeds are used in a passive activity. Note that the taxpayer must elect to treat self-charged interest as passive.
As previously discussed, passive income is generated from trade or business activities in which the person doesn’t materially participate. When a taxpayer participates regularly, continuously, and substantially in a business, their earnings are considered active income.
IRS Topic 409 defines capital assets. When an investor sells a capital asset, the difference between the adjusted basis in the asset and the amount realized from the sale is a capital gain or a capital loss. Investments are defined as capital assets.
Generally, if an investor holds the asset for more than one year before disposing of it, the capital gain or loss is long-term. If the investor holds the asset for one year or less, the capital gain or loss is short-term.
Some capital gains tax rates on passive income are lower than the rate paid on ordinary income. In 2025, long-term and short-term capital gains are taxed at different rates.
Consider these examples:
Taxpayers must separate long-term and short-term capital gains transactions for tax purposes.
For 2025, taxpayers pay ordinary income tax rates on short-term gains. The long-term gain tax rate depends on taxable income and filing status.
These are the capital gain rates, based on taxable income:
| Taxable income | Capital gains rate |
| $0 to $47,025 | 0% |
| $47,026 to $518,900 | 15% |
| Over $518,900 | 20% |
The capital gain rates for married, filing jointly taxpayers are slightly different:
| Taxable income | Capital gains rate |
| $0 to $47,025 | 0% |
| $47,026 to $291,850 | 15% |
| Over $291,850 | 20% |
Net investment income includes:
A taxpayer may incur the net investment income tax, depending on these income thresholds. An individual pays 3.8% on the lesser of:
For individual taxpayers who haven’t excluded any foreign-earned income, their modified AGI is generally the same as their regular AGI.
A taxpayer materially participates in an activity if involved in the operation of the activity on a regular, continuous, and substantial basis. If the individual materially participates in an activity, the income generated is not passive.
Material participation includes these three situations:
When assessing material participation, review these guidelines for a significant participation activity and for a personal service activity. These factors also determine when a taxpayer materially participates in an activity
Several types of income streams produce passive income.
Rental activities, including rental real estate activities, are passive activities even if the person materially participates. This category includes income from Airbnb and Vrbo properties.
Income and capital gains generated from a real estate investment trust (REIT) are defined as passive income in the everyday sense. However, REIT income is considered portfolio income under IRS rules and does not qualify for offset with passive income.
Passive income includes cash dividends paid to shareholders. Similar to REITs, dividend income is considered portfolio income under IRS rules and does not qualify for offset with passive income.
A bond ladder is a portfolio of bonds that mature at different intervals over time. For example, bonds in the portfolio might mature every three years, with some bonds maturing in three years and others maturing in ten to fifteen years.
When a particular bond matures, the principal received is reinvested in a new bond with a different maturity.
High-yield CD investors can earn a higher annual percentage yield (APY) than rates offered on other CDs. The investment may be FDIC insured, depending on the total dollars invested.
To avoid paying penalties, investors must keep dollars invested for the entire term length. Term lengths range from three months to five years, and investors earn higher rates on longer-term CDs.
High-yield savings accounts offer a higher APY than traditional savings accounts. The rate the investor earns fluctuates when the Federal Reserve changes lending rates.
Owners can make additional deposits at any time. The investment may be FDIC insured, depending on the total dollars invested.
As discussed above, a taxpayer may incur the net investment income tax on these types of income, depending on filing status and income thresholds.
A passive activity loss is the excess of passive activity deductions over passive activity income. Taxpayers can offset passive income with passive losses to reduce the tax liability.
If passive losses remain after offsetting passive income, the loss may not be deductible in the current year.
Passive activity losses (PALs) not allowed in the current year are carried forward until:
If the taxpayer or spouse actively participated in a passive rental real estate activity, the amount of the passive activity loss that is disallowed is decreased and the taxpayer therefore can deduct up to $25,000 of loss from the activity from nonpassive income. This special allowance is an exception to the general rule disallowing the passive activity loss.
The maximum special allowance of $25,000 ($12,500 for married individuals filing separate returns and living apart at all times during the year) is reduced by 50% of the amount of the modified AGI that is more than $100,000 ($50,000 if married filing separately).
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