What Counts as Active or Passive Income

Active: W-2 wages, self-employment income, and business income with material participation Passive: rental income, limited partnership interests, and businesses you do not actively run Guaranteed payments to partners for services are treated as active income Certain royalties and licensing income can be classified as passive

IRS Material Participation Tests

Test 1: 500+ hours of participation in the activity during the year Test 2: You did substantially all the work in the activity Test 3: 100+ hours and no one else participated more than you Tests 4 through 7 cover prior-year participation, personal service, and facts-and-circumstances

Passive Activity Loss Rules

Passive losses can only offset passive income, not wages or portfolio income Suspended passive losses carry forward until you have passive income or dispose of the activity A full taxable disposition of the activity releases all suspended losses The rules apply to individuals, estates, trusts, and closely held C-corps

The $25K Rental Exception

Active participants in rental real estate can deduct up to $25,000 in losses against other income The exception phases out between $100K and $150K of modified AGI Active participation is a lower bar than material participation Real estate professionals may deduct unlimited rental losses if they materially participate

Grouping Elections and NIIT

Taxpayers can group related activities to meet material participation tests collectively Once made, grouping elections are generally binding for future years The 3.8% net investment income tax applies to passive and investment income NIIT kicks in above $200K single or $250K married filing jointly AGI thresholds

Recharacterization and Planning

The IRS can recharacterize passive income as nonpassive in self-rental situations Significant participation activities may be recharacterized if you have net income Track participation hours carefully — they determine loss deductibility Proper documentation of hours is critical to defend material participation status

Active Income vs Passive Income

Curated by: Rubric Advisors

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Active vs Passive Income — Overview

Active income comes from work or businesses you materially participate in
Passive income comes from activities where you do not materially participate
The IRS uses seven tests to determine material participation status
This distinction controls how losses are treated and which surtaxes apply

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Active vs Passive Income — Overview

What Counts as Active or Passive Income

IRS Material Participation Tests

Passive Activity Loss Rules

The $25K Rental Exception

Grouping Elections and NIIT

Recharacterization and Planning

Related Topics

Tax Strategy While Owning Rental Property

Net Investment Income Tax (NIIT) & Medicare Surtax

Real Estate Professional Tax Status: Unlocking Passive Loss Deductions

Active vs Passive Income — Overview

What Counts as Active or Passive Income

IRS Material Participation Tests

Passive Activity Loss Rules

The $25K Rental Exception

Grouping Elections and NIIT

Recharacterization and Planning

Related Topics

Tax Strategy While Owning Rental Property

Net Investment Income Tax (NIIT) & Medicare Surtax

Real Estate Professional Tax Status: Unlocking Passive Loss Deductions