How to Earn Passive Income and What It Means for Your Taxes

Updated for tax year 2025

If making money with minimal effort is a dream of yours, passive income just might be the answer. But what exactly counts as passive income? Let’s look at the different ways the IRS says you can earn passive income and how it affects your taxes.

What is passive income?

Passive income is a term many self-employed professionals and business owners use to describe money earned on autopilot. You often put in the hard work up front and continue to reap the benefits with minimal effort.

On the more technical side, the IRS says this type of income can fall into one of two categories:

Trade or business activities in which you don’t materially participate during the year

Rental activities, even if you do materially participate in them (unless you are a real estate professional)

What are the tax benefits of passive income?

Aside from the obvious benefit of making money with little effort, passive income has some nice tax benefits, too.

Passive activity income, like net rental income or your share of a business you don’t materially participate in, is usually ordinary income for federal tax purposes. However, lower long-term capital gains rates may apply if the passive activity income was gained through the sale of a capital asset held for more than one year.

Long-term capital gains tax rates 2025

Tax rateSingleMarried filing jointlyMarried filing separatelyHead of household0%$0 to $48,350$0 to $96,700$0 to $48,350$0 to $64,75015%$48,351 to $533,400$96,701 to $600,050$48,351 to $300,000$64,751 to $566,70020%$533,401 or more$600,051 or more$300,001 or more$566,701 or more

What types of passive income meet the IRS rules?

For an income stream to be considered passive by the IRS, it should fall into one of the following categories.

Rental activities

Most rental properties are defined as passive income, with a few caveats.

If you’re a real estate professional, your rental income is considered active income, not passive. You also cannot claim this kind of income on “self-renting” income — for example, if you rent your property to one of your own business entities. Any income earned from leasing land does not count as passive income, either (though you may be able to take advantage of passive income loss rules in this situation).

Example of passive income rental activity: You purchase a condo or duplex and rent it out to single-family tenants. The net rental income you collect on this property is considered passive income. Short-term rentals can work differently, as explained below.

Short-term rentals

Short-term rentals are still rental income, but they may not be treated like a typical long-term rental for passive activity purposes. Under IRS rules, a property is generally not automatically classified as a passive rental activity when the average guest stay is seven days or fewer, and if you materially participate in running it, your income and losses may be non-passive, which can affect whether rental losses can offset wages and other non-passive income (sometimes called the short-term rental tax strategy).

‘No material participation’ activities

To help taxpayers determine if an income stream meets the requirements for passive income, the IRS lists seven “material participation tests.”

Ask yourself:

Did you participate in the activity for more than 500 hours?

Did your participation in the activity comprise a substantial part of all the participation in the activity during the year?

Did you participate in the activity for more than 100 hours during the year and at least as much as any other person involved?

Did you participate in multiple activities for more than 100 hours each during the year, and did your participation in all such activities exceed 500 hours when combined?

Did you materially participate in this activity for any 5 of the past 10 tax years?

Did you materially participate in this activity for any 3 of the past 10 tax years, and is the activity a personal service activity that involves your personal time and effort? Examples include health and veterinary services, consulting, performing arts, law, accounting, engineering, architecture, and actuarial science.

Did you participate in the activity on a regular, continuous, and considerable basis?

Example of a passive income activity with no material participation: You purchase a business and hire someone else to run it for you. You do not help manage the company or participate in its operations, but you earn a percentage of all business earnings.

Self-charged interest

According to the IRS, if you loan money to a pass-through entity that you own (such as a partnership or S corporation), the interest income earned on the loan can qualify as passive income if the loan proceeds are used in a passive activity. This is also true the other way around — when your S corp or partnership collects interest on a loan made to you.

Do dividends and interest count as passive income or ordinary income?

Frustratingly, the answer to this question is, “It depends.”

Dividends are ways that profits are distributed to shareholders. The IRS does not consider most dividends to be passive income; however, some dividends can qualify if they meet the following conditions:

The dividend is paid by an American corporation or “qualified foreign entity” eligible for the benefits.

You held the stock for at least 60 days within the 121-day period that ends 60 days before the ex-dividend date (ex-date).

Fittingly, dividends that meet these criteria are called “qualified dividends” and are subject to capital gains tax rates.

Can I deduct my passive activity losses against my income on my taxes?

When filing your federal tax return, you can use Form 8582 to calculate any passive activity losses (PALs) for the tax year.

You can use passive activity losses to offset profits from other passive activities, but you can’t deduct PALs against nonpassive income.

FAQs

Passive income is money you earn with little day-to-day active involvement after the income stream is set up. Common examples include rental income, dividends, royalties, interest, and income from certain businesses where you do not materially participate.For tax purposes, “passive income” has a more specific meaning. The IRS generally treats income from rental activities and businesses in which you do not materially participate as passive activity income. Passive activity rules can also limit how much passive loss you can deduct.

How do you build passive income with real estate?

One common way to build passive income with real estate is to buy property and rent it out. Rental income may come from long-term tenants, short-term rentals, multi-family properties, commercial properties, or real estate investments such as REITs.Real estate investors often try to build passive income by collecting rent, deducting eligible expenses, and benefiting from potential property appreciation. Common rental property expenses may include mortgage interest, property taxes, insurance, repairs, maintenance, utilities, professional fees, and depreciation, depending on the facts.

How is rental income taxed?

Rental income is generally taxable and must be reported on your federal tax return. You typically report rental income and expenses on Schedule E if you own rental real estate as an individual.You are generally taxed on your net rental income, not simply your gross rent. Net rental income is rental income minus deductible rental expenses, such as mortgage interest, property taxes, repairs, insurance, maintenance, certain travel costs, and depreciation.

How are qualified dividends taxed?

Qualified dividends are generally taxed at the lower long-term capital gains tax rates instead of ordinary income tax rates. For many taxpayers, those rates are 0%, 15%, or 20%, depending on taxable income and filing status. The IRS distinguishes qualified dividends from ordinary dividends, which are generally taxed as ordinary income.Some higher-income taxpayers may also owe the 3.8% Net Investment Income Tax on investment income, including certain dividends.

How is passive income taxed?

Passive income is taxed based on the type of income it is. For example, rental income is generally taxed as ordinary income after deductible expenses. Qualified dividends may receive lower capital gains tax rates. Interest income is usually taxed as ordinary income.Passive activity rules may limit your ability to deduct passive losses against nonpassive income, such as wages. In addition, higher-income taxpayers may owe the 3.8% Net Investment Income Tax on certain net investment income.

Do you pay taxes on rental income?

Yes. In general, you must report rental income on your tax return and pay tax on any taxable net rental income. However, you may be able to reduce taxable rental income by deducting eligible rental expenses, including mortgage interest, property taxes, repairs, insurance, and depreciation.

How is rental income taxed when you have a mortgage?

Having a mortgage does not make rental income tax-free. You still report rental income, but you may generally deduct the mortgage interest related to the rental property as a rental expense. The principal portion of your mortgage payment is not deductible, but the property may generally be depreciated over time, subject to IRS rules.

The bottom line

Passive income can be a smart way to earn money beyond a traditional job, but it’s important to understand how the IRS classifies that income for tax purposes. Rental activities and businesses you don’t materially participate in are common examples of passive income, but the rules can vary depending on your situation.

Use TaxAct® to file your tax return with accuracy and confidence.

This article is for informational purposes only and not legal or financial advice.

All TaxAct offers, products and services are subject to applicable terms and conditions.

Citations

“Ex-Dividend Dates.” Dividend.com, www.dividend.com/ex-dividend-dates/. Accessed 4 June 2026.United States, Internal Revenue Service. Form 8582, Passive Activity Loss Limitations. IRS, www.irs.gov/pub/irs-pdf/f8582.pdf. Accessed 4 June 2026.United States, Internal Revenue Service. Instructions for Form 8582, Passive Activity Loss Limitations. IRS, www.irs.gov/instructions/i8582. Accessed 4 June 2026.United States, Internal Revenue Service. Publication 925, Passive Activity and At-Risk Rules. IRS, www.irs.gov/pub/irs-pdf/p925.pdf. Accessed 4 June 2026.

Source link