Does Passive Income Qualify for QBI?

The Qualified Business Income (QBI) deduction, found in Section 199A of the Internal Revenue Code, represents a significant tax benefit for many small business owners and individuals. This deduction aims to reduce the tax burden on income generated through pass-through entities, such as sole proprietorships, partnerships, and S corporations. A common question is whether income typically considered “passive” can qualify for this deduction.

Understanding the Qualified Business Income Deduction

The QBI deduction, also known as the Section 199A deduction, was established to provide tax relief to owners of pass-through businesses. This deduction allows eligible taxpayers to deduct up to 20% of their qualified business income, along with 20% of qualified real estate investment trust (REIT) dividends and publicly traded partnership (PTP) income. It applies to individuals, trusts, and estates.

Qualified business income generally refers to the net amount of qualified items of income, gain, deduction, and loss from any qualified trade or business. This encompasses income from sole proprietorships, partnerships, S corporations, and certain trusts. The QBI deduction can be claimed regardless of whether a taxpayer itemizes deductions or takes the standard deduction.

The QBI deduction is subject to limitations based on the taxpayer’s taxable income. These limitations may involve the type of trade or business, the amount of W-2 wages paid by the business, and the unadjusted basis immediately after acquisition (UBIA) of qualified property. For tax year 2025, the full deduction generally applies if taxable income is below $197,300 for single filers or $394,600 for joint filers. If income exceeds these thresholds, the deduction may be limited, particularly for specified service trades or businesses (SSTBs).

Identifying Passive Income for Tax Purposes

For tax purposes, “passive income” is defined under the passive activity loss (PAL) rules, which govern how losses from certain activities can be offset against other income. A passive activity is generally one in which the taxpayer does not materially participate. This means the taxpayer’s involvement is not regular, continuous, and substantial.

Common examples of activities typically considered passive include rental activities and investments in limited partnerships. If a taxpayer fails to meet at least one of the seven material participation tests established by the IRS, the activity is generally deemed passive.

The passive activity loss rules state that losses from passive activities can only be used to offset income from other passive activities. These losses cannot typically offset active income, such as wages or income from a business in which the taxpayer materially participates. Any passive losses exceeding passive income are suspended and carried forward to future tax years.

Qualifying Passive Activities for QBI

Income can qualify for the QBI deduction only if it originates from a “qualified trade or business.” A “trade or business” for QBI purposes generally means an activity carried on for profit with regularity and continuity. This distinguishes a genuine business operation from a mere hobby or investment activity.

Most pure investment income is explicitly excluded from QBI. This includes capital gains and losses, dividends, and interest income not directly related to a trade or business. These types of income are ineligible for the QBI deduction, regardless of whether they are considered passive or active. Even if an activity is deemed passive under the PAL rules, its income can still qualify for QBI if the activity meets the definition of a “qualified trade or business” and the income is not otherwise excluded.

The crucial distinction lies between an activity being “passive” for loss limitation purposes and being a “trade or business” for QBI purposes. Being passive does not automatically disqualify income from the QBI deduction. The income must derive from an activity that rises to the level of a trade or business, which many purely passive investment activities do not.

Specific Rules for Rental Real Estate and Self-Rentals

While rental activities are generally considered passive, their income might qualify for the QBI deduction under specific circumstances. The IRS provides a safe harbor for rental real estate, outlined in Revenue Procedure 2019-38, allowing certain rental real estate enterprises to be treated as a “trade or business” for QBI purposes.

To use this safe harbor, separate books and records must be maintained for each rental real estate enterprise. For enterprises in existence for less than four years, 250 or more hours of rental services must be performed annually. For older enterprises, this 250-hour requirement must be met in at least three of the past five years. Taxpayers must also keep contemporaneous records, such as time reports or logs, detailing the hours, description, dates, and identity of those who performed the services.

Another scenario involves “self-rentals,” where a taxpayer rents property to a commonly controlled business. Under the self-rental rule, this rental income, typically passive, can be recharacterized as non-passive and potentially qualify for QBI. This applies if the rental activity and the operating business are under common control, meaning the same owner or group of owners owns at least 50% of both the rental property and the business renting it. This recharacterization allows income from such related-party rentals to be treated as income from a trade or business for QBI purposes. However, if the operating business is a specified service trade or business (SSTB), the self-rental income might also be treated as SSTB income, potentially limiting or eliminating the QBI deduction based on income thresholds.