Everyone likes making money, but there are different types of income you can receive.
Active, or ordinary, income is what most people experience. Getting money from working a job. This can also include interest income or short-term (assets held less than a year) capital gains from investments.
Passive income is income you receive without being actively engaged. The most common examples are rental income, royalties, or being an inactive owner in a business.
There is also long-term capital gains and qualified dividend income, which are treated separately and are taxed at much more favorable rates.
How You’re Taxed
I’m going to use the most basic example: a W-2 employee using the standard deduction. Assume this average person makes $60,000 a year.
They will contribute 6.2% to Social Security and 1.45% to Medicare. $12,420 is gone before they ever see it.
They will use the standard deduction, $15,750 in 2025, to reduce taxable income to $44,250. This amount is then taxed based on IRS tax brackets. $11,600 is taxed at 10%, and the remaining $32,650 is taxed at 12%. $5,518 goes to the federal government.
In total, a W-2 employee loses $17,938 in taxes. Someone who earned $60,000 from long-term capital gains pays $1,747 in federal tax (0% up to $48,351 and 15% up to $533,400).
Now, the state you are working in will want their portion, too. Depending on the state, this could range from 0% to 10.75%. States also have their own exemptions or standard deductions that don’t always match federal rules.
In Illinois, this person gets only a $2,775 exemption and then pays a 4.95% flat tax. Another $2,833 in taxes. Illinois does not care how this income was received.
What Can Be Done?
One way to pay less in taxes is to earn less. Obviously, this is not ideal. Some people even turn down raises because they fear “higher taxes,” but less than 100% is still more than 0%. You are always better off taking the raise.
To reduce your tax burden, you need to match the type of income with the type of loss. If you are a W-2 employee, you cannot offset your active income with passive losses. If you only have long-term capital gains, you can offset those with active business losses.
Or let’s say, for a completely hypothetical situation, you have a very large inherited IRA that must be emptied in 10 years. Even worse, the account has Required Minimum Distributions (RMDs). Whenever you pull from this account, it is treated as active, ordinary income. Even though it feels passive (you’re just withdrawing money), the IRS looks at where the money originally came from. It gets taxed like active income on the way out.
To offset this income and lower your tax burden, you need to generate an active loss.
Ways to Offset Active Income
What are you trying to accomplish? If it’s lowering Adjusted Gross Income (AGI), only certain deductions matter. For example, FAFSA re-adds untaxed income back in, so some strategies won’t help if college aid is the goal.
Many of the new deductions coming from the One Big Beautiful Bill Act, like “no tax on tips/overtime” and car loan interest, are below-the-line deductions. That means they do not reduce AGI. They help your tax bill but do not lower the income used for many other calculations.
Retirement contribution limits have increased for 2026. This is the simplest way to reduce taxable income. Contribution limits vary depending on the account, but almost everyone can at least put $7,500 into an IRA (income limits apply).
You can also offset income with investment losses. If an investment goes down, you can sell it and realize the loss. Just don’t re-buy the same investment within 30 days (the wash-sale rule). However, you can only deduct $3,000 of net losses per year against regular income.
If you need to offset significantly more than $3,000, you need to look at real business activity or qualifying real estate strategies.
Using Business Loss to Your Advantage
One of the most powerful tools available is bonus depreciation. Under the HR1 OBBA framework, certain business assets can qualify for 100% bonus depreciation. In simple terms, this lets you deduct the entire cost of eligible business property in the first year, instead of spreading the deduction over many years.
If you start or acquire a legitimate business, you can immediately expense qualifying purchases. This creates large, real, active losses that can offset your active income, including inherited IRA withdrawals.
But here’s the key: it must be a real business with a reasonable expectation of profit. You must materially participate. This isn’t a loophole. It’s the IRS encouraging investment and economic activity by rewarding upfront capital spending.
Becoming a Real Estate Professional
Real estate is one of the few areas where the IRS allows large non-cash deductions (depreciation) to offset active income.
If you qualify as a Real Estate Professional (REP).
Traditional long-term rentals and NNN (triple-net) leases are considered passive activities by default. Even though you “own a business,” the income is passive unless you materially participate. Because of that, the losses are normally passive as well and cannot offset active income.
Short-term rentals, however, are a special case. If the average stay is seven days or fewer, they are treated as non-passive. That means their losses are active losses. This makes short-term rentals one of the most powerful tools to offset inherited IRA withdrawals.
Buy a property, furnish it, improve it, and cost-segregate it (this breaks the building into components that depreciate faster). With bonus depreciation, you can create hundreds of thousands in legal paper losses while keeping the cash flow positive.
On top of that, you can refinance or 1031 exchange later to continue building wealth without triggering taxable events.
Being Creative
Opportunity Zones (OZs) offer another way to reduce taxes, but they only apply to capital gains—not ordinary income. They won’t directly offset inherited IRA withdrawals. However, if you sell investments at a gain before you start taking large IRA distributions, OZ funds let you defer and reduce those gains, freeing up cash flow for other tax strategies.
You can also combine strategies. For example, operating a short-term rental or starting a business inside an Opportunity Zone can offer layered benefits, including accelerated depreciation, potential capital-gain exclusion after ten years, and the ability to offset IRA income through business losses.
Conclusion
Most people only think in terms of long-term investing, but tax planning is a completely different game.
You can’t take losses that don’t help you. Passive losses don’t fix active income problems. Capital losses won’t offset required distributions from an inherited IRA. If you want real tax relief, you need real active participation through business activity or qualifying real estate strategies.
With the right structure, someone inheriting an IRA can dramatically reduce their tax bill, legally, by pairing active income with genuine active losses. It’s about matching the type of income with the type of deduction and understanding that the IRS rewards people who invest, build, and participate.
Next week, we’ll talk about how to actually start a business to help offset income.
