Capital gains refers to funds received from selling an appreciating asset, like a house or a portfolio of stocks. Passive income informally refers to making money without doing much work, but the Internal Revenue Service has its own definition of passive activity that refers to earnings from specific types of activities, including renting out property. Generally, capital gains and passive activity are treated differently for tax purposes, even though letting an asset appreciate over time is, in the plain sense of the term, a passive activity.
Although capital gains may be achieved without much work, they are fundamentally distinct from 'passive income' as classified by the IRS.
Capital Gains and Tax
When you sell an asset such as stock or even a house that you've held for less than a year, you pay tax at your ordinary marginal tax rate according to what tax bracket you're in. But if you've held on to that asset for more than a year, you instead pay tax at the long-term capital gains rate.
Generally, this will save you money, because the long-term capital gains rates are often lower than the ordinary income rates for people making the same amount of money. For example, in 2017, the top ordinary income tax bracket paid 39.6 percent in taxes, while the top capital gains rate was only 20 percent. In 2018, the top ordinary income bracket goes down to 37 percent while the top long-term capital gains rate remains at 20 percent.
In order to prevent people from using limited involvement in money-losing businesses as a tax shelter, the tax code has defined what is known as passive activity, which essentially means a business that generates income or loss that you didn't have much involvement in.
Renting property is generally considered passive activity, unless certain conditions apply, such as if you're a real estate professional. So are other business activities where you had limited participation, according to various tests published by the IRS. For instance, a business activity would not be considered passive if you spent more than 500 hours on it in a particular year, or spent at least 100 hours on it but nobody else spent more time on it than you did.
The disadvantage of having an activity classified as passive is that you can't deduct your business losses from your taxes as easily. In essence, losses from a passive activity can only offset gains from a passive activity, though you are allowed to carry your losses forward in order to use them to offset gains from the activity in a subsequent year.
There is a special rule for passive real estate rental activities, though, that allows you to deduct up to $25,000 of losses from such a business from your ordinary income.