Individual Taxation: Gross Income

Why this topic matters

Federal Taxation of Individuals is Area IV of Taxation and Regulation (REG), 22–32% of the section. It starts with gross income: under the Internal Revenue Code (IRC), gross income is all income from whatever source derived, unless a specific provision excludes it. Questions list receipts and ask which are taxable, how much, and when.

The individual tax formula

Individual tax computation
Gross income (all income − exclusions)
− Adjustments ("above-the-line" deductions)
= Adjusted gross income (AGI)
− Greater of the standard deduction or itemized deductions
− Qualified business income (QBI) deduction and other below-the-line deductions (tips, overtime, senior, car loan interest)
= Taxable income × tax rates
− Credits + other taxes (self-employment, net investment income tax) = tax due or refund

Timing

• Cash-basis individuals report income when actually or constructively received. Constructive receipt: income credited to the taxpayer's account or made available without substantial restriction (for example, a check received on December 30 is income that year, even if deposited in January).
• Prepaid rent and advance payments are generally taxable when received; security deposits are not income unless kept.
• Assignment of income: income from services is taxed to the person who earns it; income from property is taxed to the owner of the property.

Common inclusions

Item	Rule
Wages, salaries, bonuses, tips, commissions	Fully taxable (see the adjustments topic for the new tips and overtime deductions)
Interest	Taxable, including on corporate and US Treasury bonds (Treasury interest is exempt from state tax), bank deposits, and tax refunds
Dividends	Taxable to the extent of the corporation's earnings and profits; qualified dividends get capital gain rates; distributions above earnings and profits are a return of basis, then capital gain
Business and rental income	Net income reported on Schedules C and E
Prizes, awards, gambling winnings	Fully taxable (gambling losses are itemized deductions — under the One Big Beautiful Bill Act (OBBBA), limited to 90% of losses, up to gambling winnings, from 2026)
Unemployment compensation	Fully taxable
Alimony (divorce agreements before 2019)	Taxable to the recipient; post-2018 agreements: not income
Cancellation of debt	Taxable, unless excluded (bankruptcy; insolvency — to the extent insolvent; qualified farm or business real property debt; certain student loan discharges on death or disability)
State income tax refunds	Tax benefit rule: taxable only to the extent the prior-year deduction produced a tax benefit — not taxable if the taxpayer took the standard deduction
Social Security benefits	0%, up to 50%, or up to 85% taxable depending on provisional income (modified AGI + 50% of benefits)
Embezzled or illegal income	Taxable
Punitive damages; damages for emotional distress not from physical injury; lost profits	Taxable

Common exclusions

Item	Rule
Gifts and inheritances	Excluded by the recipient (income from them later is taxable)
Life insurance proceeds paid on death	Excluded (interest on installment payouts is taxable; policies bought for value lose the exclusion)
Municipal (state and local) bond interest	Excluded federally (may be an alternative minimum tax preference for private activity bonds)
Compensation for physical injury or sickness	Excluded, including emotional distress arising from the physical injury (not punitive damages)
Scholarships (degree candidates)	Excluded for tuition, fees, books, supplies, and required equipment; room and board and payments for services are taxable
Employer-provided fringe benefits	Health insurance, group-term life insurance on up to $50,000 of coverage, de minimis and working condition fringes, and others (see the payroll topic)
Foreign earned income	Up to $132,900 (2026) excluded for qualifying individuals working abroad, plus a housing exclusion
Qualified distributions from Roth accounts and Section 529 plans	Excluded
Series EE and I bond interest used for higher education	Excluded, subject to income phase-outs
Child support	Never income

Kiddie tax

A child's net unearned income above an indexed threshold is taxed at the parents' marginal rate. It applies to children under 19, or full-time students under 24 whose earned income doesn't exceed half their support. Parents may elect to report the child's income on their own return in limited cases.

Passive activity and related loss limits

Losses pass through several limits in order:

1. Basis — can't deduct more than your investment.
2. At-risk (Section 465) — amounts you could actually lose (excludes most nonrecourse debt, except qualified nonrecourse real estate financing).
3. Passive activity loss rules (Section 469) — passive losses (from rental activities and businesses in which the taxpayer does not materially participate) offset only passive income; the excess is suspended and carried forward, and is released in full when the taxpayer disposes of the entire activity in a taxable transaction.
4. Excess business loss limitation (Section 461(l)) — made permanent by OBBBA; net business losses above an indexed threshold become net operating loss carryforwards.

• Portfolio income (interest, dividends, annuities, royalties, investment gains) is not passive income and can't be sheltered by passive losses.
• Rental real estate exception: individuals who actively participate may deduct up to $25,000 of rental losses against nonpassive income, phased out by 50% of modified AGI between $100,000 and $150,000.
• Real estate professionals (more than half their personal services and more than 750 hours in real property businesses, with material participation) treat rental activities as nonpassive.

How it is tested

• Pick the taxable items from a list of receipts.
• Apply the tax benefit rule to a state refund.
• Compute the taxable portion of a scholarship or damage award.
• Apply the $25,000 rental loss allowance and passive loss rules.