For purposes of section 469 of the Internal Revenue Code, a passive activity is any activity which involves the conduct of any trade or business and in which the taxpayer does not materially participate, and the term also includes any rental activity, except as provided in the real property business paragraph (26 U.S.C. 469(c)(1) and 469(c)(2), 2024 edition). The label matters because it decides what a loss from the activity is allowed to offset.
Both halves of that first test have to hold. An activity that is not a trade or business is not a passive activity, and neither is one the taxpayer materially participates in.
Rentals Are Passive Without Regard to Participation
The rental limb is the one that surprises people, and the statute closes the obvious escape route in the very next paragraphs.
Rental activity is swept in by paragraph (2), and the working interest carve-out in paragraph (3) takes out any working interest in any oil or gas property which the taxpayer holds directly or through an entity which does not limit the liability of the taxpayer with respect to such interest. Then paragraph (4) says both of those paragraphs shall be applied without regard to whether or not the taxpayer materially participates in the activity (26 U.S.C. 469(c)(3) and 469(c)(4)).
So a landlord who does everything personally still holds a passive activity, unless the real property business paragraph reaches them. Two further paragraphs widen what counts as a trade or business for the first limb: it includes any activity involving research or experimentation within the meaning of section 174, and, to the extent provided in regulations, any activity in connection with a trade or business or any activity with respect to which expenses are allowable as a deduction under section 212 (26 U.S.C. 469(c)(5) and 469(c)(6)).
Material Participation Is Three Words, and All Three Bind
A taxpayer shall be treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis which is regular, continuous, and substantial (26 U.S.C. 469(h)(1)). It is stated as a necessary condition and as three requirements joined, not as a menu.
Two rules sit beside it. Except as provided in regulations, no interest in a limited partnership as a limited partner shall be treated as an interest with respect to which a taxpayer materially participates. And in determining whether a taxpayer materially participates, the participation of the spouse of the taxpayer shall be taken into account (26 U.S.C. 469(h)(2) and 469(h)(5)).
The looser standard that governs the rental real estate loss allowance is a different test entirely, and it is set out in active participation.
What the Label Does to a Loss
The rule is a netting rule before it is a disallowance rule.
A passive activity loss is the amount, if any, by which the aggregate losses from all passive activities for the taxable year exceed the aggregate income from all passive activities for that year (26 U.S.C. 469(d)(1)). Losses inside the passive box therefore offset income inside it first. Only the excess is the passive activity loss, and that excess is what is not allowed for the year.
It is not lost. Except as otherwise provided in the section, any loss or credit disallowed shall be treated as a deduction or credit allocable to such activity in the next taxable year (26 U.S.C. 469(b)). It carries, and it stays attached to the activity it came from.
The Rule Does Not Reach Every Taxpayer
The disallowance applies to a listed set: any individual, estate, or trust, any closely held C corporation, and any personal service corporation (26 U.S.C. 469(a)(2)). A widely held C corporation is outside that list, and so are partnerships and S corporations, which the paragraph does not name. Those two are the structures set out in pass-through entities.
Portfolio Income Is Not Passive Income
A common and expensive error is treating investment income as the passive income a passive loss can be netted against.
In determining the income or loss from any activity, there shall not be taken into account any gross income from interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business, the expenses other than interest clearly and directly allocable to that gross income, and the interest expense properly allocable to it, nor gain or loss not derived in the ordinary course of a trade or business that is attributable to the disposition of property producing that kind of income or held for investment (26 U.S.C. 469(e)(1)(A)). For purposes of that subparagraph, any income, gain, or loss which is attributable to an investment of working capital is treated as not derived in the ordinary course of a trade or business (26 U.S.C. 469(e)(1)(B)).
A dividend portfolio therefore does nothing to free up a suspended rental loss. What unearned income means in its own contexts is a separate question again.
The Two Ways Out
Dispose of the whole interest. If during the taxable year a taxpayer disposes of his entire interest in any passive activity, or former passive activity, and all gain or loss realized on the disposition is recognized, then the excess of any loss from that activity for the year, determined after applying the carryforward rule, over any net income or gain for the year from all other passive activities, also determined after applying that rule, shall be treated as a loss which is not from a passive activity (26 U.S.C. 469(g)(1)(A)). Selling to a relative does not do it. Where the taxpayer and the person acquiring the interest bear a relationship described in section 267(b) or section 707(b)(1), that release does not apply to any loss until the interest is acquired in such a transaction by another person who does not bear that relationship (26 U.S.C. 469(g)(1)(B)).
Qualify under the real property business paragraph. Where it applies, the rental sweep does not apply to the taxpayer’s rental real estate activity for that year, and the section is applied as if each interest in rental real estate were a separate activity, though the taxpayer may elect to treat all such interests as one activity, and nothing in that subparagraph affects the determination of whether the taxpayer materially participates with respect to any interest in a limited partnership as a limited partner (26 U.S.C. 469(c)(7)(A)). It applies only where both of two tests are met: more than one-half of the personal services performed in trades or businesses by the taxpayer during the year are performed in real property trades or businesses in which the taxpayer materially participates, and the taxpayer performs more than 750 hours of services during the year in real property trades or businesses in which the taxpayer materially participates. On a joint return those requirements are satisfied if and only if either spouse separately satisfies them (26 U.S.C. 469(c)(7)(B)).
What a Passive Activity Is Not
- Not passive income in the everyday sense. The phrase in ordinary use means money arriving without work. Here it is a defined statutory category, and interest and dividends are expressly outside it.
- Not the same as active participation. That is the separate and looser rental real estate standard behind the special loss allowance, worked through in active participation.
- Not a permanent denial. A disallowed loss carries forward attached to its activity, and a fully taxable disposition of the entire interest releases what is left.
Common Questions
Either of two routes. A trade or business in which the taxpayer does not materially participate, or a rental activity, which counts regardless of participation unless the real property business paragraph applies.
Not as a general matter. Losses from passive activities net against income from passive activities first, and only the excess is disallowed for the year, so wages and portfolio income sit outside the netting.
It is treated as a deduction allocable to the same activity in the next taxable year and keeps carrying until the activity produces enough passive income to absorb it, or until the taxpayer disposes of the entire interest in a fully taxable transaction to an unrelated person.
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