Capital gains and income

Capital gain vs. ordinary gain rates

Ordinary income includes wages, salaries, and interest earned and is typically taxed at the taxpayer’s tax rate on taxable income. Capital gains are realized on the sale of a security, real estate, or other asset held for investment. This gain can be short-term (held for one year or less) or long-term (held for more than one year). The taxation on capital gains is generally lower, especially for long-term gains, encouraging longer-term investments. See Schedule D instructions for various capital gain worksheets.

For 2025, long-term capital gains are generally taxed at 0%, 15%, or 20% based on taxable income (collectibles gain at up to 28% and unrecaptured section 1250 gain at up to 25%) - for example, 0% up to $48,350 (single) or $96,700 (married filing jointly), 15% up to $533,400 (single) or $600,050 (married filing jointly), and 20% above that. Short-term capital gains don’t get this preferential treatment - they’re taxed at the taxpayer’s ordinary income rates.

Definitions

Capital gain

Profit realized from the sale of a capital asset such as stocks, real estate, or other investments. Short-term capital gains (assets held one year or less) are taxed at ordinary income rates. Long-term capital gains (assets held more than one year) are generally taxed at lower preferential rates.

Ordinary income

Income from wages, salaries, self-employment, interest, and other non-capital sources, taxed at the taxpayer’s regular marginal tax rate.

Installment sales

When at least one payment is received after the year of sale, the installment method applies automatically unless the taxpayer elects out. It applies only to a gain: a sale at a loss can’t be reported on the installment method, and a deductible loss (on business or investment property) is taken entirely in the year of sale. The taxpayer can:

• Either recognize the gain in the year of sale or
• Receive a portion of the gain in payments over a period of time

Example: Sale of land

Here is a step-by-step example of calculating the profit percentage for an installment sale of land:

Scenario:
Selling price: $100,000
Adjusted basis (cost plus selling expenses): $40,000
Terms: $20,000 down payment in the year of sale, and the remaining $80,000 paid in four equal annual installments of $20,000 each (plus interest).

Calculation steps:
Calculate the gross profit: This is the total gain you expect to make on the sale.
Gross profit = selling price - adjusted basis
Gross profit = $100,000 - $40,000 = $60,000

Determine the contract price: The contract price is generally the total selling price minus any liabilities (like a mortgage) the buyer assumes, up to your basis in the property. In this simple example with no mortgage, the contract price is the same as the selling price.
Contract price = $100,000

Calculate the gross profit percentage: This percentage determines the portion of each payment that is considered profit.
Gross profit percentage = (gross profit / contract price) * 100
Gross profit percentage = ($60,000 / $100,000) * 100 = 60%

Reporting the gain
Using the 60% gross profit percentage, you report 60% of each principal payment received as taxable gain for that year. The remaining 40% is a tax-free return of your basis. The interest is reported on Schedule B, Form 1040.

Each $20,000 payment received - the down payment and each of the four annual installments - produces the same taxable gain:
Taxable gain = $20,000 * 60% = $12,000 per payment

Definitions

Adjusted basis

The original cost of a property plus capital improvements and minus any depreciation taken. It is used to calculate the gain or loss on the sale of an asset.

Gross profit percentage

The ratio of total expected gain to the contract price of an installment sale, expressed as a percentage. It determines what portion of each installment payment received is recognized as taxable gain for that year.

Contract price

In an installment sale, the total amount the buyer agrees to pay the seller, generally equal to the selling price minus any liabilities assumed by the buyer that do not exceed the seller’s basis in the property.

Sidenote

Basis adjustments

Accumulated depreciation on rental or other income-producing property will lower the adjusted basis. Mortgage or other loan debt assumed by the buyer does not lower basis; it is subtracted from the selling price to figure the contract price. Capital improvements, which add to a property’s value or prolong its life, increase basis; repairs, insurance premiums, mortgage payments, and annual real estate taxes generally do not.

Refer to form IRS Form 6252 for application of installment sale calculations.

Supplemental income

Rental income

Rental income is derived from use of tangible property and is reported on Schedule E, Form 1040. Types of rental income include:

• Advance rent payments
• Payments for cancelling a lease
• Expenses paid by a tenant
• Property or service in lieu of rent
• Repairs or maintenance for the property owner

A security deposit is not included in rental income until it is used by the landlord or owner in the event that the tenant has violated any of the terms of the lease or agreement.

Note: Rental activity that includes substantial services primarily for the tenant’s convenience, i.e., regular cleaning, changing linen, or maid service, is reported on Schedule C and subject to SE tax.

Personal property rentals. Schedule E covers rental real estate, including personal property leased with the real estate. Renting out other personal property, such as equipment or vehicles, is reported on Schedule C if the taxpayer is in the business of renting it (the primary purpose is income or profit and the activity has continuity and regularity), and that income is subject to SE tax. If the rental is for profit but isn’t a business, the income goes on Schedule 1, line 8l, and the expenses are deducted as an adjustment to income on Schedule 1, line 24b; the income isn’t subject to SE tax. If the property isn’t rented for profit, deductions are limited and a loss can’t offset other income.

Rental activities are generally considered passive and are subject to passive activity loss (PAL) limits. A taxpayer who qualifies as a real estate professional can treat losses from rental real estate activities in which they materially participate as non-passive - deductible against ordinary income - but the activity is still reported on Schedule E, not Schedule C. To qualify, the taxpayer must spend more than half of their personal working time in real property trades or businesses in which they materially participate, and work more than 750 hours in those trades or businesses during the year.

Taxpayers who don’t qualify as real estate professionals are passive activity taxpayers. Those with active participation - making management decisions such as approving tenants or repairs, and owning at least 10% of the property - can still:

• Deduct up to $25,000 of passive losses against ordinary income if modified adjusted gross income (MAGI) is $100,000 or less. Above that, the $25,000 is reduced by 50% of the MAGI over $100,000, so it phases out between $100,000 and $150,000 of MAGI and is fully phased out at $150,000 or more.
• Carry forward unused passive losses indefinitely, as tracked on Form 8582.

Passive activities also include leasing equipment and limited partnerships, in addition to rental real estate.

Definitions

Passive activity

A trade or business in which the taxpayer does not materially participate. Rental activities are generally treated as passive under IRS rules, meaning losses can typically only be deducted against other passive income.

Passive activity loss (PAL)

A loss from a passive activity that exceeds passive income. PALs cannot be deducted against ordinary (non-passive) income in the current year; they are suspended and carried forward to offset future passive income or recognized when the entire activity is disposed of.

Real estate professional status

A tax classification that allows a taxpayer to treat rental activities as non-passive if they meet specific IRS requirements: working more than 750 hours in real property trades or businesses in which they materially participate, and spending more than half of their personal working time in those activities.

Rental of vacation home

The Internal Revenue Service (IRS) has specific guidelines to determine whether your property is considered a personal residence, a rental property, or a mixed-use property, and these classifications impact how you report income and deduct expenses.

• Rented fewer than 15 days during the year: the rental income is excluded from taxable income, and rental expenses aren’t deductible. Personal expenses such as mortgage interest and property taxes remain deductible on Schedule A if the taxpayer itemizes, subject to the usual limitations.
• Rented 15 days or more during the year: all rental income received must be reported, and ordinary and necessary expenses related to the rental activity can be deducted. How much of those expenses is deductible depends on whether the property is classified as a residence or a non-residence for tax purposes.

Royalty income

A royalty is a payment made to an asset owner (licensor) for the right to use their property. The payments are typically a percentage of revenue or a fixed fee per unit sold, allowing the owner to earn money as others profit from their creation, and are defined in legal licensing agreements that detail terms, duration, and calculation methods.

Royalty income is derived from use from your work or investment in the following:

• Oil, gas, and mineral properties as well as
• Use of intangible properties i.e., patents, trademarks, copyrights.
• Works by artists, writers, and musicians
• Books
• Film/Media
• (Distributive shares of profit or loss from partnerships and S corporations are not royalties; they are also reported on Schedule E, in Part II.)

Royalty income and loss recognition

In all scenarios, ordinary and necessary expenses incurred to produce the royalty income are deductible. These can include operating costs, maintenance, and for mineral properties, depletion allowances.

• Business income (Schedule C): If a taxpayer is in the business of being a self-employed writer, artist, inventor, or holds an operating mineral interest, the royalty income and expenses are reported on a IRS Schedule C, Profit or Loss From Business (Sole Proprietorship). In this case, a net loss can typically be used to offset other types of ordinary income, subject to general business loss limitations, such as the excess business loss rules.
• Supplemental income (Schedule E): If the royalties are not derived from a trade or business (e.g., inherited mineral rights or investment property), they are generally reported as supplemental income or loss on IRS Schedule E, Supplemental Income and Loss. Royalties not derived from a trade or business are portfolio income, not passive income, so the passive activity loss (PAL) rules generally do not apply to them.
• Sale of property (Schedule D): Gains or losses from the sale or exchange of intellectual property or mineral property held as an investment are generally treated as capital gains or losses and reported on IRS Schedule D, Capital Gains and Losses. However, a copyright or a literary, musical, or artistic work created by the taxpayer’s own efforts is not a capital asset, so its sale produces ordinary income.

Recognizing a tax loss is a standard accounting practice when expenses exceed revenue. The classification of the royalty activity determines which specific IRS form is used and what loss limitations apply.

Definitions

Royalty

A payment made to the owner of an asset (the licensor) for the right to use that asset. Royalties are typically calculated as a percentage of revenue or a fixed fee per unit and are governed by licensing agreements.

Depletion allowance

A tax deduction for the gradual exhaustion of natural resources (such as oil, gas, or minerals) extracted from the ground. Similar to depreciation for physical assets, it allows the owner to recover the cost of the resource over time.

Schedule K-1 information

Schedule K-1 is a tax reporting document for a shareholder or partner’s distributive shares of net income, losses, and separately stated deductible and nondeductible expenses from an S corporation or partnership, respectively. Shareholders and partners in pass-through entities, such as S-corporations and partnerships, must maintain accurate records of their investment basis. This is critical for tax compliance, as distributions from the company - detailed on the annual Schedule K-1 - can become taxable capital gains if they exceed the owner’s adjusted basis. Schedule K-1 is also used to report the same from estates and trusts to beneficiaries. Schedule K-1s must be furnished by the date the entity’s return is required to be filed: the 15th day of the third month after year-end for partnerships and S corporations (March 15 for calendar-year entities), and the 15th day of the fourth month for estates and trusts (April 15 for calendar-year). Click on links below to view the forms: Form 1065 (Schedule K-1) and Form 1120-S (Schedule K-1).

Definitions

Schedule K-1

A tax reporting document issued to shareholders, partners, or beneficiaries showing their proportionate share of income, deductions, credits, and other tax items from a pass-through entity such as a partnership, S-corporation, estate, or trust. Recipients use this form to report their share on their individual tax return.

Distributive share

A partner’s or shareholder’s allocated portion of a pass-through entity’s income, gain, loss, deduction, or credit, as specified in the partnership agreement or, for an S corporation, pro rata by shares held each day. The distributive share is reported on Schedule K-1 and flows through to the individual’s tax return.

Publicly traded partnerships (PTPs)

A publicly traded partnership is a partnership whose interests trade on an established securities market or are readily tradable on a secondary market. A PTP is taxed as a corporation unless at least 90% of its gross income is qualifying income, such as interest, dividends, real property rents and gains, and income from mineral or natural resource activities. A PTP that meets this test is taxed as a partnership and gives each partner a Schedule K-1 (Form 1065) with the PTP box (item D) checked. The passive activity rules apply separately to each PTP: a passive loss from a PTP offsets only income from the same PTP and is otherwise suspended and carried forward, an overall net gain from a PTP is nonpassive income, and the $25,000 rental real estate allowance doesn’t apply. PTP items aren’t reported on Form 8582. Suspended losses are freed when the partner disposes of the entire interest to an unrelated person in a fully taxable transaction.