What Is Passive Activity Income for Tax Purposes?

Federal tax law classifies income into distinct categories to determine how it is taxed and which deductions apply. Income generally falls into one of three broad categories: active income, portfolio income, or passive activity income. Active income includes wages, salaries, and income from a trade or business where a taxpayer materially participates. Portfolio income encompasses earnings from investments, such as interest, dividends, annuities, and royalties not derived in the ordinary course of a trade or business.

Defining Passive Activity

A passive activity involves any trade or business where the taxpayer does not materially participate. This definition also includes all rental activities, regardless of the taxpayer’s involvement, unless an exception applies. The Internal Revenue Service (IRS) outlines specific tests to determine material participation. Meeting any one of these tests means the activity is not passive.

One test requires participation for more than 500 hours during the tax year. Another considers participation that constitutes substantially all of the activity by all individuals, including non-owners. A third test is met if the individual participates for more than 100 hours, and their participation is not less than any other individual’s. This applies to significant participation activities, where the taxpayer participates for over 100 hours but does not otherwise materially participate.

Other material participation tests include participation for any five of the preceding ten taxable years. A test also applies if the activity is a personal service activity, and the individual materially participated in it for any three preceding taxable years. A facts and circumstances test can also apply, requiring regular, continuous, and substantial participation during the year. Meeting any of these tests means income from that activity is active, not passive.

Common Passive Activities and Income Sources

Certain activities are considered passive. Rental activities, for instance, are broadly classified as passive under the tax code, regardless of the owner’s involvement. This applies whether the property is residential or commercial. An exception exists for real estate professionals who meet specific criteria, allowing their rental income to be treated as active.

Interests in limited partnerships are another source of passive income. A limited partner does not materially participate in the partnership’s management or operations. Therefore, income and losses from a limited partnership interest are passive.

Businesses where an owner does not materially participate also generate passive income. For example, a silent partner who provides capital but has no direct involvement in operations generates passive income. Similarly, if an individual owns a business but delegates all management duties, their income from that business is passive.

Understanding Passive Activity Losses

Classifying an activity as passive impacts how losses are treated. Under federal tax law, losses generated from passive activities (Passive Activity Losses or PALs) can generally only be deducted against income from other passive activities. This means that a loss from one passive venture cannot typically be used to offset active income, such as wages or salary, or portfolio income, like interest or dividends. This limitation was established to prevent taxpayers from using passive losses to reduce their taxable income from other sources.

If PALs exceed passive income in a tax year, the excess losses are not immediately deductible. These “suspended losses” are carried forward indefinitely to future tax years, where they can offset passive income. Suspended losses can also be deducted in full when the taxpayer disposes of their entire interest in the passive activity in a fully taxable transaction.

There are exceptions that allow some passive losses to be deducted against non-passive income. One exception applies to rental real estate activities where the taxpayer “actively participates.” This rule permits individuals to deduct up to $25,000 of passive losses from rental real estate against non-passive income, provided their modified adjusted gross income does not exceed certain limits. This $25,000 deduction begins to phase out for taxpayers with modified adjusted gross income exceeding $100,000 and is completely eliminated at $150,000. Another exception involves qualified real estate professionals, who, if they meet specific hours of service and material participation tests, can treat their rental real estate activities as non-passive, allowing them to deduct losses without the passive activity limitations.

Who is Affected by Passive Activity Rules

The passive activity rules apply to several types of taxpayers, primarily aimed at preventing the use of passive losses to offset active or portfolio income. Individuals are directly subject to these rules for any passive activities they engage in. This includes sole proprietors, partners in partnerships, and shareholders in S corporations who do not materially participate in their businesses.

Estates and trusts are also subject to the passive activity rules. Passive losses generated within an estate or trust face the same limitations as those incurred by individuals.

Closely held C corporations are also affected by the passive activity rules, but with a modified application. A closely held C corporation is generally defined as a C corporation where more than 50% of its stock is owned by five or fewer individuals. For these corporations, passive losses can offset passive income and active income from the corporation’s trade or business. However, they cannot offset portfolio income.

Personal service corporations are another category of entity subject to these rules. A personal service corporation is generally a C corporation where the principal activity is the performance of personal services, and such services are substantially performed by employee-owners. For these entities, the passive activity rules apply in the same manner as they do for individuals. This means passive losses can only be offset against passive income, preventing these corporations from using passive losses to reduce their service income.