Passive Income
Passive income, as defined by the IRS, is income derived from rental activities or from trade or business activities in which the taxpayer does not materially participate. It is a distinct tax category that determines how losses from these activities can be deducted, generally limited to offsetting other passive income rather than ordinary income or portfolio income.
The IRS recognizes three categories of income for purposes of applying the passive activity loss rules: active (or earned) income, passive income, and portfolio income. The passive activity rules were enacted in 1986 as part of the Tax Reform Act to prevent high-income taxpayers from using paper losses from tax shelters to offset wages and investment income. Understanding these categories is essential for investors involved in rental real estate, limited partnerships, S corporations, and LLCs in which they are not active participants.
Passive income is generated primarily from two sources: rental activities and business activities in which the taxpayer does not materially participate. The IRS has established seven tests for material participation, the most common of which is participating in the activity for more than 500 hours during the year. If a taxpayer fails to meet any of the seven tests, their interest in the activity is passive.
Losses from passive activities can only be used to offset passive income. If passive losses exceed passive income in a given year, the excess is suspended and carried forward to future years — it cannot be used to reduce wages, capital gains, or interest income. When a taxpayer disposes of their entire interest in a passive activity in a fully taxable transaction, any remaining suspended losses are released and can offset income from any source.
Rental real estate is treated as a passive activity under the general rule, but there are two important exceptions. First, if a taxpayer actively participates in rental real estate (a lower bar than material participation) and has MAGI of $100,000 or less, they may deduct up to $25,000 of rental real estate losses against non-passive income. This allowance phases out between $100,000 and $150,000 of MAGI. Second, qualifying real estate professionals who spend more than 750 hours per year and more than 50% of their personal service time in real property trades or businesses may treat rental activities as non-passive.
Passive income from partnerships and S corporations is reported to investors on Schedule K-1. The character of the income (passive versus nonpassive) is determined at the entity level and flows through to the individual return, where it interacts with the passive activity loss rules.
For tax purposes, passive income is also relevant in calculating the Net Investment Income Tax (NIIT) — a 3.8% surtax on the lesser of net investment income or the amount by which MAGI exceeds $200,000 ($250,000 for married filing jointly). Passive income from trade or business activities is included in net investment income for NIIT purposes.