Section 13.2: Types of Income and Capital Gains

  • 1️⃣ Ordinary Income

  • 2️⃣ Earned Income

  • 3️⃣ Investment Income (Portfolio Income)

  • 4️⃣ Passive Income

  • 5️⃣ Capital Gains and Losses

  • 6️⃣ Short-Term vs. Long-Term Capital Gains

Ordinary Income:

  • Ordinary income is the total of several types of income combined:

    • Earned Income

    • Investment Income

    • Passive Income

  • This total is used to determine your income tax rate — how much you owe in federal income taxes.

Earned Income

  • Income from active work — when you trade time or labor for pay.

  • Examples:

    • Salary

    • Wages

    • Bonuses

    • Tips

    • Income from actively running a business

  1. ✅ For most people, earned income makes up all or most of their taxable income.

Investment Income (Portfolio Income):

  • Income earned from investments, not work.

  • Comes from assets you own, not from active participation.

  • Examples:

    • Dividends (from stocks)

    • Interest (from bonds, savings, etc.)

  1. 💡 Key point: Investment income is sometimes called portfolio income.

Passive Income:

  • A type of investment income that comes from certain investments where you are not actively involved.

  • Common sources:

    • Direct Participation Programs (DPPs) — such as limited partnerships

    • Real estate investments

  • These investments can generate both:

    • Passive income

    • Passive losses

  1. Tax rule:
    ➡️ Passive losses can only offset passive income (not earned or portfolio income).

Capital Gains and Losses:

  • When an investor closes (sells) a position for a profit, they realize a capital gain.

  • If sold for less, it’s a capital loss.

  1. Capital gains are taxable, but how they’re taxed depends on how long the investment was held.

Income & Gains

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Income & Gains 〰️

Short-Term vs. Long-Term Capital Gains

Type / Holding Period / Tax Treatment / Typical Rate

  • Short-Term / 1 year or less / Taxed as ordinary income / Higher rate

  • Long-Term / More than 1 year / Taxed at lower capital gains rate / Lower rate

    • 💡 Key insight:
      Even though short-term gains are legally not part of “ordinary income,” they are added to ordinary income when calculating your tax bracket — effectively making them taxed the same way.

Quick Summary Table

Type of Income / Source / Active or Passive / Typical Tax Rate

  • Earned Income / Salary, wages, tips / Active / Ordinary income rate

  • Investment (Portfolio) Income / Dividends, interest / Passive / Ordinary income rate

  • Passive Income / DPPs, real estate / Passive / Ordinary income rate (can offset passive losses)

  • Short-Term Capital Gains / Investment held ≤ 1 year / Passive / Ordinary income rate

  • Long-Term Capital Gains / Investment held > 1 year / / Passive / Lower capital gains rate

✺ Review questions ✺

  • Earned income, investment income, and passive income.

  • Salary, wages, bonuses, tips, etc.

  • Also called portfolio income; examples: dividends and interest.

  • Mainly from direct participation programs (limited partnerships) and real estate.

  • Passive losses can offset passive income only.

    • Short-term: held 1 year or less → taxed as ordinary income.

    • Long-term: held more than 1 year → taxed at lower rate.

  • Short-term capital gains are taxed at a higher rate (the same as ordinary income).