Three Types of Income

By Jason Watson, CPA
Posted Sunday, May 25, 2025

Let’s back up a bit. Our book loves to spill the beans so-to-speak with the net-net fun facts, and then dig a hole under the house for the foundation. Wow. All kinds of metaphors. There are three types of income- earned, portfolio and passive.

Earned Income

Earned income is income that is a direct result of your labor. This income is usually in the form of W-2 wages or as small business income reported on Schedule C of your individual tax return (Form 1040). Both are subject to Social Security and Medicare taxes (self-employment taxes). There are other areas such as Schedule E or F where income can come into your individual tax return and be subject to self-employment taxes, but Schedule C is the most common.

Portfolio Income

Portfolio income is income generated from selling an asset, and if you sell that asset for a higher price than what you paid for it originally, you will have a gain. Depending on the holding period of the asset, and other factors, that gain might be taxed at ordinary income tax rates or capital gains tax rates. Interest and dividends are other examples of portfolio income.

Capital gains are not a form of income per se. Capital gains simply defines how your portfolio income will be taxed. Income is income, and is therefore taxed. This income might be taxed at capital gains rates or ordinary rates. Subtle difference.

Portfolio income is not subjected to self-employment taxes, but it might be subjected to net investment income tax (NIIT). See our section on real estate professional status (REPS) which side-steps NIIT.

Passive Income

We touched on this in a previous section. Passive income bluntly is income that would continue to generate if you died. Morbid. How about this? Passive income is income that would continue to generate if you decided to do nothing and sunbathe on some beach. That sounds better. Passive income includes rental property income and royalties, and income from businesses or investment partnerships / multi-member LLCs where you do not materially participate.

Passive income is also not subject to self-employment taxes but similar to portfolio income, it might be subject to the Net Investment Income Tax (NIIT). So, if you own a rental property, the net income (profit) generated from the activity is considered passive income although your participation might be considered active. If you take this same rental activity and provide certain services such as tours, your income might be considered earned income and subject to self-employment taxes.

Additionally, if you wrote a book and receive royalty checks, that income is also passive and not subjected to self-employment taxes. However, if you write several books or make updates to an existing book (like this one) then you are materially participating in your activity and your income is earned income. And Yes, you would pay self-employment taxes on that income.

You might also intentionally want passive income to offset or absorb your passive losses. We talk about passive income generators (PIGs) in a later section. No, you cannot manufacture passive income to allow passive losses to be deducted with self-rentals.

Self-Rentals

It is common for a business owner who relies on machinery or equipment, including real estate such as an office building, to have two business entities. One entity is an LLC that owns the assets. The other entity is an S corporation which leases the assets from the LLC for use in the business.

Treasury Regulations Section 1.469-2 boringly reads-

(f)(6) Property rented to a non-passive activity. An amount of the taxpayer’s gross rental activity income for the taxable year from an item of property equal to the net rental activity income for the year from that item of property is treated as not from a passive activity if the property-

(i) Is rented for use in a trade or business activity (within the meaning of paragraph (e)(2) of this section) in which the taxpayer materially participates (within the meaning of Section 1.469-5T) for the taxable year; and

(ii) Is not described in Section 1.469-2T(f)(5).

Read that first paragraph again. The phrase “treated as not from a passive activity” tends to stand out. This essentially means you cannot use a self-rental to generate a bunch of passive income to offset your otherwise non-deductible passive losses.

In turn this would suggest that you cannot benefit from a cost segregation study or rental losses in general since you would be limited by passive activity loss limits (more on that in a bit). However, under Treasury Regulations 1.469-4(c)(1), you can group the business activity with the self-rental activity to create an economic unit. This would allow you to offset income from the business operations with losses from the self-rental.

This makes sense right? If your business simply purchased a warehouse or office building directly, and leveraged a cost segregation study to accelerate depreciation for a quick and substantial tax deduction, it generally would not be limited. But if you owned the real estate in a separate entity and lease it back to your business, the self-rental suddenly becomes limited? The answer is No, but there are some rules.

Either the activity is insubstantial when compared to the other activity or has the same proportionate ownership interest in the rental activity. The regulations also mention similarities and differences in types of business, the extent of common control and ownership, and geographical location. In the case of an owner-occupied warehouse or office building, these criteria are usually met. Moreover, the Section 199A qualified business income deduction would normally not be allowed with a self-rental, but when aggregated under Treasury Regulations 1.469-4(c)(1), it remains applicable.

Keep in mind that similarly to other grouping elections such as Treasury Regulations 1.469-9(g) which allows rental activities to be grouped as one, the grouping of your business and your self-rental must continue unless there is a material change in the facts and circumstances that renders the grouping inappropriate.