What Is Passive Income? Rentals, Losses, and the 3.8% Tax

Passive income, for federal tax purposes, is money you earn from a business you own but don’t actively help run, or from renting out property. The label matters because the tax code walls this income off from your other earnings: losses from passive activities can generally only offset income from other passive activities, not your paycheck, your interest, or your stock dividends. That rule, set out in Internal Revenue Code Section 469, is why the classification quietly shapes how millions of people report rental losses, side-business income, and investment stakes each year.

The Three Income Buckets

The tax system sorts every dollar you earn into one of three categories, and the category controls what you can do with any related losses.

Active (earned) income. Wages, salaries, commissions, tips, and net earnings from a business you run day-to-day. If you’re meaningfully involved in producing the income, it’s active.
Portfolio income. Returns on investments you hold: interest, dividends, and capital gains from selling stocks or bonds. Portfolio income sits in its own lane and generally cannot be offset by passive losses either.
Passive income. Earnings from a trade or business in which you don’t materially participate, plus nearly all rental income.

The buckets often surprise people. Interest from a savings account, dividends from stocks, and gains from selling securities all sound like the definition of “passive” in everyday speech, but for tax purposes they’re portfolio income, not passive income. Royalties can go either way depending on how involved you are with the underlying property. License a patent and just collect checks, and the income is typically portfolio. Receive royalties through a business you don’t help run, and the income may be passive.

What Makes a Business Activity Passive

For a trade or business, the dividing line is material participation. If you materially participate, your share of the income or loss is active. If you don’t, it’s passive. The IRS gives you seven tests, and you only need to pass one for the activity to count as active for the year.¹

You participated more than 500 hours during the year.
Your participation was substantially all the participation by everyone involved, including non-owners.
You participated more than 100 hours, and no one else participated more than you did.
You had several “significant participation” activities (more than 100 hours each), and your combined hours across them topped 500.
You materially participated in the activity in any five of the previous ten years.
The activity is a personal service field (health, law, accounting, consulting, and similar), and you materially participated in any three prior years.
Based on all facts and circumstances, you participated more than 100 hours on a regular, continuous, and substantial basis, and no one else was paid to manage the activity.

Hours have to be documented. The IRS expects contemporaneous records, meaning daily logs or calendar entries kept as you go. Reconstructing hours after the fact, especially during an audit, rarely goes well.

Entity type shifts which tests you can use. Members of an LLC and shareholders in an S corporation have access to all seven tests. A limited partner in a limited partnership can only rely on three: the 500-hour test, the five-of-ten-prior-years test, and the personal service activity test.¹

Rental Income Is Passive by Default

Rental activities are treated as passive automatically, no matter how many hours you spend on them. You could repaint every unit yourself, screen every tenant, and take every repair call, and the activity is still passive under the default rule. Congress carved out a few exceptions that matter for anyone with rental property.

The $25,000 Special Allowance

If you actively participate in a rental real estate activity, you can deduct up to $25,000 of net rental losses against non-passive income like your salary.¹ Active participation is a lower bar than material participation: you need to own at least 10% of the property and make management decisions such as approving tenants, setting rent, and authorizing repairs.

An income phase-out limits who benefits. The $25,000 allowance shrinks by 50 cents for every dollar your modified adjusted gross income exceeds $100,000, and it disappears entirely at $150,000. For married couples filing separately who lived together during the year, the allowance is halved to $12,500 and the phase-out starts at $50,000. These thresholds are not indexed for inflation, so more taxpayers lose access each year as incomes rise.

Real Estate Professional Status

A taxpayer who qualifies as a real estate professional can treat rental real estate as non-passive, with no dollar cap on losses that flow against wages, business income, or investment returns.¹ Qualifying takes two things during the year: more than half of all your personal services across every trade or business must be in real property trades or businesses where you materially participate, and you must log more than 750 hours in those real property activities. For married couples, one spouse can qualify alone, but hours can’t be pooled between spouses to meet the threshold.

Qualifying gets you the status, but it doesn’t automatically make each rental non-passive. You still need to show material participation in each individual rental, or make a grouping election to treat all your rentals as one activity and then pass a material participation test for the group.

Short-Term Rentals

Not every rental is a “rental activity” for these rules. If the average period of customer use is seven days or less, the IRS does not classify it as a rental activity at all.¹ That matters for vacation rentals, Airbnb-style properties, and hotel-like operations. Because the activity isn’t a rental activity, it escapes the automatic passive label. It’s treated like any other trade or business, and your material participation decides whether the income and losses are active or passive.

What Happens to Passive Losses

The core rule is blunt: passive losses can only be deducted against income from other passive activities.¹ If your rental property loses $30,000 this year and your only other income is a $150,000 salary, you generally can’t use that rental loss to reduce your tax bill at all.

Losses that can’t be used don’t disappear. Any excess passive loss becomes a suspended loss that carries forward indefinitely, waiting for future passive income to absorb it. Suspended losses stay tied to the specific activity that created them, and you track them activity by activity on Form 8582.²

The main way to unlock suspended losses is a complete disposition. Sell your entire interest in a passive activity in a fully taxable transaction, and all accumulated suspended losses from that activity become deductible at once, against any type of income. A partial sale won’t do it. A gift won’t do it, because it isn’t taxable to you. If the owner dies, suspended losses are allowed on the final return only to the extent they exceed any step-up in basis the heir receives, so a portion of the losses can be permanently lost at death.

Common Traps: Manufactured Passive Income

Because passive losses need passive income to absorb them, some taxpayers try to create passive income on purpose. The IRS anticipated this and built rules that reclassify certain income out of the passive bucket.

The self-rental rule is the one that catches the most people. If you rent property to a business in which you materially participate, the net rental income from that property is recharacterized as non-passive.¹ A business owner who rents a building to their own company might expect that rent to be passive income they could use to soak up other passive losses. It isn’t. Worse, the recharacterization is asymmetric: net rental income becomes active, but any net rental loss stays passive.

A similar rule targets “significant participation” activities, meaning businesses where you put in more than 100 hours but don’t clear any material participation test. If your combined net income from all those activities is positive, that net income is recharacterized as active, which keeps it from offsetting passive losses elsewhere.

The Extra 3.8% Tax on Passive Income

Passive income can carry a surtax that active income doesn’t. The 3.8% Net Investment Income Tax applies to individuals with modified adjusted gross income above $200,000 for single filers, $250,000 for married filing jointly, and $125,000 for married filing separately.³ The tax hits the lesser of your net investment income or the amount by which your MAGI exceeds the threshold.

Income from a trade or business that is passive to you counts as net investment income subject to this surtax. So do rental income and gains from selling passive business interests. Active business income is excluded. Two taxpayers with identical business income can end up at different effective tax rates depending only on whether they materially participate. Estates and trusts hit the surtax at much lower income levels than individuals, and none of the individual thresholds are indexed for inflation, so more taxpayers cross them each year.

That surtax, combined with the loss limitation rules, is why the passive label carries real weight. Whether a stream of income is passive is not a bookkeeping curiosity: it changes what you can deduct, when you can deduct it, and how much tax you owe on the income itself.

1
Internal Revenue Service. Publication 925 (2025), Passive Activity and At-Risk Rules
2
Internal Revenue Service. Form 8582 – Passive Activity Loss Limitations (2025)
3
Internal Revenue Service. Topic No. 559, Net Investment Income Tax