Are Capital Gains Passive Income or Portfolio Income?

For most investors, capital gains are not passive income. The IRS treats profits from selling stocks, bonds, mutual funds, and similar investments as portfolio income, which is a separate legal category with its own rules. Capital gains only count as passive income in narrower situations, mainly when you sell a rental property or an interest in a business you didn’t materially participate in. The distinction is not academic. It controls which losses you can use against which gains.

The Three Income Categories the IRS Uses

Federal tax law sorts your income into three buckets: earned income (wages, salaries, self-employment), portfolio income (interest, dividends, capital gains from investments), and passive income (earnings from rentals or businesses in which you don’t materially participate).¹ The categories exist mainly to keep taxpayers from using losses in one bucket to wipe out gains in another.

Portfolio income is defined as gains from property that produces interest, dividends, annuities, or royalties, or property held for investment.² Sell a stock at a profit and the gain lands there. Same for gains on bonds, ETFs, and mutual funds.

The wall between portfolio and passive matters in practice. Say you own a rental generating $10,000 in passive losses this year and you also sold a stock for a $10,000 profit. You generally cannot use the rental losses against the stock gain. The IRS treats them as belonging to separate worlds, even though neither is a paycheck.³

When a Capital Gain Is Treated as Passive

A capital gain takes on the character of the activity that produced the underlying asset. If the activity was passive, the gain on selling it is passive too. Two scenarios cover most cases:

Selling rental real estate. All rental activities are treated as passive under the tax code regardless of how many hours you put in, so gains on the sale generally count as passive income. The main exception is the real estate professional rule, below.¹
Selling a limited partnership interest. Limited partners are typically passive by default because the partnership structure limits their role in day-to-day operations. A gain on selling that interest is passive.

This is where a real planning opportunity opens up. Suspended passive losses that piled up from a rental or other passive venture over the years can be used against a passive gain when you finally sell. Dispose of your entire interest in a passive activity in a fully taxable sale to an unrelated buyer, and all suspended losses from that activity are released at once and become deductible against any type of income.³ The same release applies to partners disposing of an entire partnership interest and to S corporation shareholders selling all their stock. On an installment sale, the suspended losses come out proportionally as you recognize gain each year.

Material Participation Decides Business-Interest Sales

Whether a business interest was passive or non-passive during your ownership turns on the material participation tests. Meeting any one of them makes the activity non-passive. Three come up most often:³

You participated in the activity for more than 500 hours during the tax year.
Your participation was substantially all of the participation by anyone, including non-owners.
You participated more than 100 hours and no other individual participated more than you did.

Two additional tests look at prior years. Material participation in any five of the preceding ten tax years qualifies. For personal service activities like consulting or law, three preceding years is enough. A final facts-and-circumstances test exists but doesn’t apply if you logged 100 hours or fewer, and management time doesn’t count if someone else was paid to manage or spent more hours managing than you did.

When you sell an interest in a business, whether you met these tests during the years you held it decides whether the gain is passive or non-passive. Getting this wrong is the kind of error that invites closer scrutiny.

The Real Estate Professional Exception

Because rentals are passive by default, the only way to make rental gains non-passive is to qualify as a real estate professional. Two thresholds must be cleared in the same tax year:³

More than 750 hours of services in real property trades or businesses where you materially participated.
More than half of all the personal services you performed across every trade or business during the year were in those real property activities.

The second test is the one people fail. A full-time employee with a demanding day job and a side portfolio of rentals will almost certainly miss the majority-of-time test even after 800 hours of evening and weekend real estate work. Hours worked as an employee in real estate don’t count unless you own at least 5% of the employer. On a joint return, each spouse is evaluated separately for the two threshold tests.

Qualify, and rental income and gains shift from passive to non-passive, which changes both loss-offset math and the Net Investment Income Tax analysis.

The $25,000 Active-Participation Allowance

Short of full professional status, there is a smaller carve-out. If you actively participated in a rental (a lower bar meaning you made management decisions like approving tenants or setting rent), you can deduct up to $25,000 in passive rental losses against non-passive income each year. The allowance phases out $1 for every $2 of modified adjusted gross income over $100,000 and disappears at $150,000. If you’re married filing separately and lived with your spouse at any point during the year, the allowance is zero. Married-filing-separately filers who lived apart the entire year get a $12,500 allowance with a phaseout starting at $50,000.³ Losses that exceed the allowance or fall out through the phaseout carry forward and release in full when you sell the property.

How Loss Rules Differ Between the Two Categories

The reason the passive-versus-portfolio line is worth caring about is that losses behave differently in each bucket.

Capital (Portfolio) Losses

Capital losses first offset capital gains in the same year. If losses exceed gains, you can deduct up to $3,000 of the excess against ordinary income ($1,500 if married filing separately).⁴ Anything left carries forward indefinitely. The $3,000 cap has been the same since 1978 and isn’t indexed for inflation.

Passive Losses

Passive losses can only offset passive income. If you have $20,000 in passive losses and $5,000 in passive income, you use $5,000 this year and suspend $15,000 for future years, when it’s allocated among your passive activities and treated as deductions from them.³ The full release comes only on a complete disposition of the activity.

Where the Two Categories Get Treated Alike: The NIIT

Much of the confusion between capital gains and passive income traces to the Net Investment Income Tax, a 3.8% surtax that lumps them together. Under 26 U.S.C. §1411, it applies to the lesser of your net investment income or the amount by which your modified adjusted gross income exceeds a threshold: $200,000 single, $250,000 married filing jointly, $125,000 married filing separately.⁵ Those thresholds haven’t been adjusted for inflation since the tax took effect in 2013, so more filers cross the line every year.

Net investment income for NIIT purposes includes taxable interest, dividends, capital gains, rental income, royalties, and income from passive business activities. That single calculation treating both categories the same is likely why so many people assume they’re the same thing. They aren’t. For loss-offset purposes, the wall stays up. The NIIT is figured on Form 8960 and paid on top of your regular income tax and capital gains tax.⁶

1
Office of the Law Revision Counsel. 26 USC 469 – Passive Activity Losses and Credits Limited
2
Internal Revenue Service. Publication 550 (2024), Investment Income and Expenses
3
Internal Revenue Service. Publication 925 (2025), Passive Activity and At-Risk Rules
4
Office of the Law Revision Counsel. 26 USC 1211 – Limitation on Capital Losses
5
Office of the Law Revision Counsel. 26 USC 1411 – Imposition of Tax
6
IRS. 2025 Instructions for Form 8960 – Net Investment Income Tax