Passive vs nonpassive income: what a passive loss can offset
A table of which income is passive and which is not, with the rule behind each line, and why a sale gain is the key.
By Hans Goldstein, Enrolled Agent, admitted to practice before the IRS ·
The table
| Income | Passive? | Source |
|---|---|---|
| Wages, salary, bonuses, self-employment income from a business you work in | No | IRC 469(e)(3); Pub. 925 'personal service income' |
| Interest, dividends and royalties not in a trade or business | No (portfolio) | IRC 469(e)(1) |
| Gain on stocks, bonds and investment property | No (portfolio) | IRC 469(e)(1)(A)(ii) |
| Interest on an installment note from selling a passive activity | No (portfolio) | Temp. Reg. 1.469-2T(c)(3) |
| Net rental income from a passive rental | Yes | IRC 469(c)(2) |
| Income from a business where you do not materially participate | Yes | IRC 469(c)(1) |
| Gain from selling a passive activity or property used in it | Yes | Temp. Reg. 1.469-2T(c)(2); Pub. 925 |
| K-1 income from a trade or business where you materially participate | No (non-passive) | IRC 469(c)(1) |
| Net rental income from property you rent to a business in which you materially participate (self-rental) | No (recharacterized as non-passive) | Pub. 925, 'Recharacterization of Passive Income'; Reg. 1.469-2(f)(6) |
| Covenant not to compete payment | No | Pub. 925 |
| Social Security and other retirement benefits | No | Pub. 925 'personal service income' |
| Income from a limited partnership interest (trade or business) | Yes, generally | IRC 469(h)(2) |
Recharacterized income
Some net income from passive activities is treated as non-passive so that it cannot soak up passive losses.
Pub. 925 lists significant participation passive activities, rental of property when less than 30% of the unadjusted basis is subject to depreciation, equity-financed lending, rental of property incidental to development, rental of property to a non-passive business, and licensing of intangible property by pass-through entities.
If the net result of one of these is a loss, it is treated like any other passive loss; if it is net income, it is recharacterized and kept off Form 8582.
Can passive losses offset depreciation recapture?
Yes, when the recapture is part of the gain on selling a passive activity. Depreciation recapture is part of the gain from the disposition, and gain from the disposition of property used in a passive activity is passive income (Pub. 925).
Its character does not change: it is still taxed as ordinary income (section 1245) or at up to 25% (unrecaptured section 1250 gain), and the allowed losses are separate deductions. See the recapture calculator.
Gain on a sale is passive income, usually
This is the rule that makes a sale work. Pub. 925 says passive activity income "generally includes gain from disposition of an interest in a passive activity or property used in a passive activity."
The gain therefore absorbs suspended losses on Form 8582, and in a full taxable sale the Form 8582 instructions say the gains are entered there "so that the gains might offset other PALs."
What the gain does not do is change the character of the loss that is then allowed, or its rate; see allowed versus which rate.
Two exceptions in Pub. 925 can make a sale gain non-passive: property that you used in more than one activity in the 12 months before the sale, where the gain is allocated by use (an allocation to the main activity is accepted if your interest is worth no more than the lesser of $10,000 or 10% of the activity's property), and substantially appreciated property (fair market value over 120% of adjusted basis) that was used in a passive activity for less than 20% of your holding period and not for the entire 24 months before the sale.
Why it matters
If you have a large passive loss but no passive income, it stays suspended. Building passive income, by buying a profitable passive investment or selling a passive activity at a gain, is the other way to use it. See the complete guide and the section 469 map.
Sources and dates
- 26 USC 469(c), (e), (h)(2).
- Temp. Reg. 1.469-2T(c).
- IRS Publication 925 (2025), Passive Activity and At-Risk Rules, "Passive Activity Income and Deductions" and "Recharacterization of Passive Income."
Checked against the sources above on October 30, 2026. Dollar figures are 2026 federal (Rev. Proc. 2025-32) unless the page says otherwise. Education only, not tax or legal advice for your situation.
Questions
What counts as passive income?
Income from passive activities: rental activities, and trade or business activities in which you do not materially participate. It generally includes gain from selling an interest in a passive activity or property used in one (Pub. 925).
Is rental income passive income?
Yes, unless the activity is not a rental under the regulations, or you are a real estate professional who materially participates (IRC 469(c)(2), (7)).
Is interest or a dividend passive income?
No. Interest, dividends and royalties not derived in the ordinary course of a trade or business are portfolio income, and so are other items of portfolio income listed in IRC 469(e)(1). Passive losses cannot offset them.
Is a salary passive income?
No. Earned income such as wages and compensation for personal services is never passive income (IRC 469(e)(3)).
Is gain on selling a rental property passive?
Generally yes, if the property was used in a passive activity in the year of sale. Exceptions exist for property used in more than one activity in the prior 12 months and for substantially appreciated property that was used in a passive activity for only part of the holding period (Pub. 925).
What is recharacterization?
A rule that turns net income from certain passive activities into non-passive income so that passive losses cannot offset it. Examples include renting property to a business you materially participate in and equity-financed lending (Pub. 925, 'Recharacterization of Passive Income').
Related
- Section 469 passive activity rules
- Suspended passive losses: the complete guide
- Do passive losses offset capital gains?
- Form 8582 explained
- All passive loss guides
Run my numbers with Hans: book a scope call
Hans Goldstein is an Enrolled Agent, admitted to practice before the Internal Revenue Service. Not affiliated with or endorsed by the IRS. He is not a CPA or attorney. Education only, not tax or legal advice for your situation.