If you put food on the table by heading into a job and collecting a paycheck, most other means of generating income may seem so hands-off that they qualify as passive income. While this rule of thumb seems logical, it’s not accurate: The Internal Revenue Service strictly defines passive income to include only a few revenue streams. Because of this, capital gains and other investment income aren’t treated as passive income.
Passive Income Defined
Only two types of activities generate passive income as defined by the IRS. Rental activity, including rents and other fees paid to a landlord, are considered a passive revenue stream. Investing in companies but not providing hands-on direction is also a passive activity. This definition doesn’t apply to stock ownership, but merely financial arrangements in which an investor serves as a “silent partner,” bankrolling a business venture while leaving its day-to-day operations up to others.
Earned vs. Unearned Income
Passive income may be confused with unearned income, which is also known as portfolio income. Unearned income is any source of money derived from investments, such as dividends, interest or capital gains. In contrast, earned income is payment received from work or other services provided. Although earned income may be casually referred to as active income, the IRS treats earned and unearned revenue as earned income, and revenue from either of these sources can’t be offset by losses from passive activity.
Passive Activity and Losses
If you’re involved in a passive activity, such as owning a business property, the IRS provides you with a potential deduction that isn’t available to active earnings: You may claim up to $25,000 in passive losses each year, providing you with a chance to significantly lower your adjusted gross income. These losses must be limited to actual passive activities, however: Your passive losses include only the amount that expenses and depreciation exceed rent. Although income you generate from a rental property is considered passive, sales of business properties are treated as sale of a capital asset.
Capital Gains and Losses
Because you can’t treat capital gains or losses as a passive activity, you lose the potential for large deductions associated with passive business activities. Capital losses are first applied to offset capital gains: If you had $8,000 in gains and $7,000 in losses, you claim $1,000 in gains, which are taxed at a different rate than earned income. If your losses exceed your gains, you may claim them as a deduction against your adjusted gross income, although the IRS allows you to claim up to only $3,000 in capital losses each year and roll any excess losses forward into future tax years.