If you put food on the table by heading into a job and collecting a paycheck, most other means of generating income might seem so hands-off that they qualify as passive income. While this rule of thumb seems logical, it’s not accurate.
Capital Gains Defined
The Internal Revenue Service strictly defines passive income to include only a few revenue streams, and the election to treat capital gains as passive income does not exist. A capital gain is an increase in value of a capital asset, such as an investment property or stocks, that makes them worth more than they were when you purchased them. However, until the capital asset is sold, you will realize no gains. Capital gains can be short-term – held for a year or less – or long-term assets held for more than a year. When a capital asset is sold, then the proceeds from the sale are taxable. But, just how much you're taxed depends on several factors, including whether or not it was held as a long or short-term asset.
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, according to passive activity rules.
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 activity loss 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.
According to the Internal Revenue Service, capital gains are not considered passive income.