How is passive income taxed differently from earned income in 2025?
The IRS treats passive and earned income very differently, and understanding the distinction can significantly affect your tax planning.
What counts as earned income?
Wages, salaries, tips, self-employment income, and net earnings from a business you actively participate in. Earned income is subject to:
- Ordinary income tax at your marginal rate (10% to 37%)
- FICA taxes: Social Security (6.2% on wages up to $176,100 in 2025) and Medicare (1.45%, plus 0.9% Additional Medicare Tax above $200,000 single / $250,000 joint)
- If self-employed: you pay both employer and employee FICA shares (15.3% combined), but deduct half as a business expense
What counts as passive income?
Income from activities you do not materially participate in. The most common types:
| Type | Tax Treatment |
|---|---|
| Rental income (net of expenses) | Ordinary income rates; no FICA |
| Qualified dividends | 0%, 15%, or 20% depending on income |
| Ordinary (non-qualified) dividends | Ordinary income rates |
| Long-term capital gains (held >1 year) | 0%, 15%, or 20% |
| Short-term capital gains (held <1 year) | Ordinary income rates |
| Interest income | Ordinary income rates |
| Partnership/S-Corp passive distributions | Ordinary income rates; may avoid FICA |
The Net Investment Income Tax (NIIT)
If your MAGI exceeds $200,000 (single) or $250,000 (married filing jointly), an additional 3.8% tax applies to passive income. This applies to investment income but not earned income.
Passive activity loss rules
You generally cannot use passive losses (such as rental property losses) to offset earned income. Passive losses can only offset passive income. Exception: if your AGI is below $100,000 and you actively participate in your rental property, you may deduct up to $25,000 in rental losses against ordinary income. This phases out entirely above $150,000 AGI.
Qualified Business Income (QBI) deduction
If you have income from a pass-through entity (LLC, S-Corp, partnership, sole proprietorship), you may deduct up to 20% of qualified business income under the OBBBA-made-permanent QBI deduction, effectively lowering the rate on that income.
Bottom line for tax planning
Earned income always faces the highest combined rate (income tax plus FICA). Long-term capital gains and qualified dividends benefit from lower rates. Rental income lands in the middle: ordinary rates, but no FICA and potentially sheltered by depreciation deductions.
Sources
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