Passive Income

Passive income, in the tax sense defined by Section 469, is income from a trade or business in which the taxpayer does not materially participate, most commonly rental real estate activities, which are treated as passive by default regardless of participation. The distinction matters because of the passive activity loss rules: losses from passive activities can generally only offset income from other passive activities, not wages or portfolio income such as interest and dividends, with disallowed losses suspended and carried forward until the taxpayer has passive income to absorb them or disposes of the activity. For real estate investors, this has several practical consequences. Fractional, professionally managed investments such as Delaware Statutory Trust interests generate passive income to the investor, since the investor takes no active role, which can be useful for absorbing suspended passive losses from other rental holdings. The default passive characterization of rental income also generally subjects it to the 3.8% net investment income tax for higher earners. An important exception exists for real estate professionals who meet the material participation and hours tests under Section 469(c)(7), whose rental activities can be treated as non-passive, allowing losses to offset other income and potentially avoiding the net investment income tax. Whether income or loss is passive is a fact-specific determination with significant tax consequences and should be analyzed with a tax advisor.