Active income: taxed like wages
Active income comes from Joe Taxpayer materially participating in work: consulting, rideshare driving, bookkeeping, or any gig where he is doing the labor. The IRS treats this as earned income subject to ordinary income tax rates plus self-employment tax (15.3% on net profit, with a partial deduction).
- Pros: Earned income can support retirement contributions (IRA/solo 401(k)); losses may offset other non-passive income.
- Cons: Subject to self-employment tax; requires quarterly estimated payments; must issue 1099s/keep books.
Passive income: you are not materially participating
Passive income generally comes from activities where Joe is an investor, not a daily operator—like limited partnership interests or rental real estate where he does not meet material participation tests. Passive losses usually cannot offset active income; they carry forward until there is passive income or the activity is disposed.
- Pros: No self-employment tax on most passive income; losses can shelter other passive income.
- Cons: Losses are trapped if no passive income; net investment income tax (NIIT) of 3.8% may apply above thresholds.
Capital gains: a separate bucket
Capital gains are taxed based on holding period. If Joe Taxpayer holds an investment more than one year, gains are long-term with preferential rates (0%, 15%, or 20%). Short-term gains (held one year or less) are taxed at ordinary rates. Capital gains are generally not subject to self-employment tax.
When sales become self-employment
If Joe is in the business of flipping items—cars, sneakers, or crypto—regularly and with a profit motive, the IRS can reclassify those gains as business income subject to self-employment tax. Occasional sales from a personal portfolio are typically capital gains.
Examples with Joe Taxpayer
Example 1: Joe the designer (active)
Joe earns $80,000 designing logos as a freelancer. This is active self-employment income. He owes ordinary income tax plus self-employment tax on net profit. He can deduct business expenses and contribute to a solo 401(k).
Example 2: Joe the landlord (passive)
Joe owns a rental that nets $12,000 after expenses. He does not meet material participation tests. The income is passive—no self-employment tax. If he had a passive loss, it would generally carry forward until he has passive income or sells the property.
Example 3: Joe the investor (capital gains)
Joe holds an S&P 500 ETF for 18 months and sells for a $10,000 gain. That is long-term capital gain at preferential rates and no self-employment tax. If he sold after six months, it would be short-term and taxed at ordinary rates.
Example 4: Joe the frequent flipper (self-employment risk)
Joe buys and sells collectible sneakers every week, advertising on social media. Even if he labels profits as "capital gains," the IRS can treat this as inventory and business income with self-employment tax and required bookkeeping.
Choosing the right path
- Document your role. Track hours and decisions to show whether you materially participate.
- Separate investing from business. A personal buy-and-hold portfolio usually keeps capital gains treatment; high-frequency flipping can lose it.
- Plan for payroll/self-employment tax. Set aside cash for quarterly estimates if you have active self-employment income.
- Mind the NIIT. If modified AGI exceeds thresholds ($200k single / $250k married filing jointly), passive income and capital gains may incur the 3.8% NIIT.
Bottom line for Joe Taxpayer:
Active income builds retirement space but triggers self-employment tax. Passive income avoids self-employment tax but traps losses and can incur NIIT. Capital gains get the best rates if you hold long enough, but frequent flipping can be recast as self-employment. Know which bucket you are in before you file.
