How to Calculate Passive Income for IRS Purposes

To calculate passive income for IRS purposes, take the gross receipts from each passive activity, subtract the allowable expenses tied to it, and treat the result activity by activity before combining. The working formula is simple: Net Passive Income = Gross Passive Revenue − (Operating Expenses + Mortgage Interest + Depreciation). The complications sit on either side of that line — figuring out which income counts as passive in the first place, and figuring out what you can actually deduct when the number comes out negative.

What Counts as Passive Income

The IRS sorts income into three buckets: active (wages and business income where you’re hands-on), portfolio (interest, dividends, capital gains), and passive. Only two sources produce passive income: rental real estate where you aren’t operating as a real estate professional, and any trade or business in which you don’t materially participate.¹ A limited partnership interest is the classic example of the second type.

Rental real estate is automatically treated as passive for most taxpayers, even if you spend significant time managing the property.²

One boundary worth stating up front: dividends and interest are not passive income. The IRS classifies those as portfolio income, and the distinction matters because passive losses cannot offset portfolio gains.² Putting brokerage income into your passive calculation is one of the fastest ways to draw scrutiny.

Running the Calculation on Each Activity

You calculate net passive income separately for every activity, then aggregate the results. For a rental property, gross receipts means every rent payment collected during the year before any deductions. From that, subtract the deductible costs tied to the property:

Property management fees (commonly 8% to 12% of monthly rent)
Insurance premiums
Repair and maintenance costs
Property taxes
Mortgage interest
Depreciation on the building and any equipment

If the number is positive, that amount is added to your taxable income for the year. If it’s negative, you have a passive activity loss, and the deductibility question moves to the loss rules below.

A Worked Example

Assume a rental duplex generated $30,000 in rent during the year. Expenses: $3,600 in property management fees, $2,400 in insurance, $4,500 in repairs, $3,200 in property taxes, $7,800 in mortgage interest, and $8,700 in depreciation. Total expenses come to $30,200. The net result is a $200 passive loss for that activity. Whether you can deduct that $200 against wages this year, or whether it gets suspended, depends on the rules that follow.

What Happens When the Result Is a Loss

Here’s the rule that catches most people off guard: passive losses can only offset passive income. If your rental loses $10,000 but your only other income is a $90,000 salary, you can’t deduct that $10,000 against your wages.³ The loss gets suspended and carries forward, waiting for future passive income to absorb it.

Three exceptions to this rule change what shows up on your return.

The $25,000 Rental Loss Allowance

Rental property owners who actively participate in managing their properties can deduct up to $25,000 in rental losses against nonpassive income like wages, even though rental income is technically passive. Active participation is a lower bar than material participation: making genuine management decisions like approving tenants, setting rental terms, and authorizing repairs.⁴

You need at least a 10% ownership interest, and limited partners generally don’t qualify. The allowance phases out with income:

MAGI up to $100,000: full $25,000 available
MAGI between $100,000 and $150,000: allowance shrinks by $1 for every $2 of income above $100,000
MAGI of $150,000 or more: allowance is fully gone

Married taxpayers filing separately who lived with a spouse at any point during the year cannot use this allowance at all. If you lived apart the entire year, the cap drops to $12,500 and the phaseout begins at $50,000 of MAGI.⁴

At-Risk Rules Apply First

Before the passive activity rules even engage, losses are limited by a separate at-risk cap. You can only deduct losses up to the amount you have at risk in the activity, generally money contributed plus amounts borrowed for which you’re personally liable. Nonrecourse loans from people who have an interest in the activity generally don’t count as at-risk amounts. Anything disallowed here carries forward to the next year.⁵

Selling Releases Suspended Losses

Accumulated suspended losses don’t vanish. When you sell your entire interest in a passive activity in a fully taxable transaction, you can deduct all previously disallowed losses in the year of the sale, including against nonpassive income. The word that does the work is “entire” — selling a partial interest doesn’t trigger the release. Unused passive activity credits don’t get the same treatment.³

Confirming the Activity Is Really Passive

The whole calculation assumes the income is passive to begin with. For rental property, that’s the default. For a business, whether income is passive turns on whether you materially participate. The IRS provides seven tests, and meeting any one of them makes the activity active for the year:⁶

500-hour test: more than 500 hours of participation during the year.
Substantially all: your involvement was essentially all of the work anyone did in the activity.
100-hour test: more than 100 hours, and no other person participated more than you.
Significant participation aggregation: more than 100 hours in several activities, with combined hours across them exceeding 500.
Five-of-ten-years test: material participation in the activity for any five of the last ten tax years.
Personal service activity: the activity involves personal services (law, medicine, accounting, consulting, performing arts) and you materially participated in any three prior years.
Facts and circumstances: participation on a regular, continuous, and substantial basis.

Fail all seven and the income is passive. Keep a contemporaneous log with dates, tasks, and hours. Without documentation the IRS defaults to passive treatment, and you argue from behind.

Real Estate Professional Exception

Rental income is automatically passive for most taxpayers no matter how many hours they put in. The real estate professional exception overrides that automatic treatment so rental losses can offset wages. Two requirements both must be met:¹

More than half of your personal services for the year were performed in real property businesses in which you materially participated.
More than 750 hours of services during the year in those real property businesses.

For married couples filing jointly, only one spouse needs to meet both tests, but hours from both spouses can’t be combined. Employee hours in real estate don’t count toward these thresholds unless you own at least 5% of the employer.¹ Qualifying as a real estate professional still leaves you needing to materially participate in each rental activity for its losses to be treated as nonpassive.

Other Taxes That Attach to the Number

Once you have a net passive income figure, other tax provisions may adjust what you owe on it.

The 3.8% Net Investment Income Tax

Higher earners owe an additional 3.8% surtax under IRC Section 1411 on the lesser of net investment income or the amount by which MAGI exceeds:⁷

$250,000 for married filing jointly or qualifying surviving spouse
$200,000 for single or head of household
$125,000 for married filing separately

Net investment income explicitly includes rents, royalties, and income from passive activities.⁷ These thresholds aren’t inflation-adjusted. With $60,000 in net rental income and MAGI of $280,000 filing jointly, the 3.8% tax applies to $30,000, adding $1,140 to your bill.

No Self-Employment Tax, Possible QBI Deduction

Passive income is generally exempt from the 15.3% self-employment tax that hits active business owners (12.4% Social Security plus 2.9% Medicare).⁸ A landlord collecting $50,000 in net rental income avoids roughly $7,650 in self-employment tax a sole proprietor earning the same amount would owe.

Rental income from a qualifying trade or business may also be eligible for the Section 199A qualified business income deduction of up to 20% of qualified business income. Originally set to expire after 2025, the deduction was made permanent by the One Big Beautiful Bill Act signed in 2025. A safe harbor exists specifically for rental real estate enterprises, treating them as a trade or business for QBI purposes if certain requirements are met.⁹

Records You Need to Support the Numbers

The calculation is only as good as the records behind it. For each activity, keep:

Gross receipts: every payment received before deductions.
Operating expense records: management invoices, insurance statements, repair receipts, property tax bills.
Form 1098: your lender sends this if you paid $600 or more in mortgage interest during the year.¹⁰
Depreciation schedules: cost basis and annual depreciation for the building and major improvements over the applicable recovery period.
Schedule K-1 (Form 1065): partnerships and multi-member LLCs report your share of income, deductions, and credits on this form.¹¹
Material participation log: contemporaneous dates, hours, and tasks for each activity.
Mileage records: the 2026 standard business mileage rate is 72.5 cents per mile for driving to properties for inspections or repairs.¹²

Where the Numbers Go on Your Return

Passive income and expenses reach the return through several forms:

Schedule E (Form 1040): the primary form for rental real estate income, royalties, and your share of partnership or S corporation income. Part I is where you list gross rents and deduct expenses like taxes, interest, repairs, insurance, management fees, and depreciation line by line.¹³
Form 8582: required when total passive losses exceed total passive income. This form calculates the allowable loss after applying the passive activity rules, including the $25,000 rental allowance.¹⁴
Schedule K-1: kept for your records, not filed with the return unless specifically required.¹¹

You can skip Form 8582 if rental real estate is your only passive activity, you actively participate, total rental loss is $25,000 or less, MAGI is $100,000 or less, and there are no prior-year suspended losses.¹⁴ Otherwise, anyone with passive activities and net losses needs to file it.

What Getting It Wrong Costs

Misclassifying active income as passive, or the reverse, to gain a tax advantage carries real consequences. The standard accuracy-related penalty is 20% of the underpayment attributable to the error. For gross valuation misstatements, that rate doubles to 40%.¹⁵ Interest runs on the underpayment from the original due date.

The most common trigger isn’t fraud. It’s inadequate records. Taxpayers who can’t substantiate their hours of participation lose the material participation argument by default, income gets reclassified as passive, losses that offset wages get disallowed, additional tax comes due, and the 20% penalty stacks on top. The contemporaneous activity log is the single document that prevents that outcome.

1
Office of the Law Revision Counsel. 26 USC 469 – Passive Activity Losses and Credits Limited
2
Internal Revenue Service. Publication 527 (2025), Residential Rental Property
3
Internal Revenue Service. Topic No. 425, Passive Activities – Losses and Credits
4
Internal Revenue Service. Publication 925, Passive Activity and At-Risk Rules
5
Office of the Law Revision Counsel. 26 USC 465 – Deductions Limited to Amount at Risk
6
eCFR. 26 CFR 1.469-5T – Material Participation (Temporary)
7
Office of the Law Revision Counsel. 26 USC 1411 – Imposition of Tax
8
Internal Revenue Service. Self-Employment Tax (Social Security and Medicare Taxes)
9
Internal Revenue Service. Qualified Business Income Deduction
10
Internal Revenue Service. Publication 936 (2025), Home Mortgage Interest Deduction
11
Internal Revenue Service. Partners Instructions for Schedule K-1 (Form 1065)
12
Internal Revenue Service. IRS Sets 2026 Business Standard Mileage Rate at 72.5 Cents per Mile, Up 2.5 Cents
13
Internal Revenue Service. Instructions for Schedule E (Form 1040)
14
Internal Revenue Service. 2025 Instructions for Form 8582 – Passive Activity Loss Limitations
15
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments