Portfolio and Investment Income

Generally preferential rates, no payroll tax, and subject to the 3.8% NIIT above the thresholds.

Interest

Earnings from bank accounts, certificates of deposit (CDs), or bonds. Taxed as ordinary income unless generated by municipal bonds. References: Form 1099-INT, IRS Pub. 550, “Investment Income and Expenses”.

Capital Gains

Profit on the sale of a capital asset as defined in IRC §1221, “Capital asset defined”. The holding period test of IRC §1222, “Holding period” — more than one year — separates long-term gain, taxed on the preferential schedule of IRC §1(h), from short-term gain, taxed as ordinary income. Watch the two special rates: 25% on unrecaptured §1250 gain from depreciated real property and 28% on collectibles. Reference: Schedule D (Form 1040).

Section 1231 Gains: The Best Character in the Code

Property used in a trade or business and held over a year — rental buildings, equipment, farmland — falls under IRC §1231, “Property used in the trade or business”, which grants the most favorable treatment available anywhere: net gains are taxed as long-term capital gain, while net losses are fully deductible as ordinary losses against any income, with no $3,000 cap. Heads you win at 20%, tails you deduct at 37%.

Two conditions attach. Depreciation recapture comes out first as ordinary income under IRC §1245 (personal property) or as 25% unrecaptured gain under IRC §1250 (real property). And IRC §1231(c) imposes a five-year lookback: net §1231 gain is recharacterized as ordinary to the extent you claimed ordinary §1231 losses in the prior five years, which stops you from alternating loss years and gain years to claim both benefits.

Section 1256 Contracts

Regulated futures, options on futures, and cash-settled broad-based index options are marked to market at year end under IRC §1256 and taxed 60% long-term / 40% short-term regardless of how long you held them. Covered in section “Taxation of Equity Options”; the placement decision is in section “Derivatives Inside Retirement Accounts”.

Original Issue Discount

Bonds issued below face, including zeros and TIPS inflation accretion, generate taxable interest under IRC §1272, “Original issue discount” before you receive any cash — the “phantom income” problem that argues for holding these instruments in a retirement account (section “Zero-Coupon Bonds and STRIPS”).

Dividends

Corporate distributions to shareholders. Qualified dividends are taxed at capital gains rates, while ordinary dividends are taxed at ordinary income rates. References: Form 1099-DIV, IRS Pub. 550.

Rental Income

Net revenues from leasing real estate. Reported on Schedule E, allowing deductions for depreciation, mortgage interest, and property taxes; the passive-loss, personal-use, and recapture nuances are in section “Rental Income”. References: Schedule E (Form 1040), IRS Pub. 527, “Residential Rental Property”.

Royalties

Income from licensing intellectual property, patents, copyrighted works, or natural resource extraction rights (such as oil and gas leases). Reported on Schedule E and taxed as ordinary income, unless the taxpayer is in the business of creating or selling the underlying assets, in which case it is Schedule C earned income.

Annuities

Periodic payments from insurance or investment contracts. Tax treatment depends on whether the annuity was funded with pre-tax or after-tax dollars. Reference: IRS Pub. 939, “General Rule for Pensions and Annuities”.

Retirement Distributions

Withdrawals from pensions, traditional IRAs, and 401(k)-type accounts. Pre-tax contributions and their earnings are taxed as ordinary income on distribution; qualified Roth distributions are tax-free (section “Roth IRA”). Sequencing these withdrawals is the subject of chapter “Tax-Efficient Decumulation”.

Social Security Benefits

Up to 85% of benefits are included in taxable income once provisional income crosses statutory thresholds (section “The Social Security Tax Torpedo”). Reported on Form SSA-1099.