No, passive income is not considered earned income under IRS rules. The two sit in separate categories: earned income is pay for personal services you perform, while passive income comes from a trade or business you are not actively involved in, or from rental real estate. That distinction changes your payroll tax bill, whether you can fund an IRA, whether you qualify for the Earned Income Tax Credit, how the Social Security earnings test hits you, and what you can do with business losses.
What Counts as Earned Income
The IRS defines earned income as compensation you receive for personal services. That includes wages, salaries, tips, commissions, bonuses, non-cash pay such as the fair market value of goods received in a barter, and net earnings from self-employment when your own effort produced the income.1Office of the Law Revision Counsel. 26 U.S.C. 32 Earned Income – Section: (c) Definitions and Special Rules Union strike benefits count too.2Internal Revenue Service. Earned Income Pensions, annuities, and income earned while incarcerated are specifically excluded.
Employees see earned income reported on Form W-2. Self-employed people calculate it on Schedule SE attached to Form 1040.3Internal Revenue Service. Instructions for Schedule SE (Form 1040)
What Counts as Passive Income
Passive income comes from a trade or business activity in which you do not materially participate — meaning you are not involved on a regular, continuous, and substantial basis.4Internal Revenue Service. Topic No. 425, Passive Activities – Losses and Credits Rental real estate is treated as passive regardless of how many hours you spend on it, unless you qualify as a real estate professional. A limited partnership interest with no management role is another typical example.
Portfolio Income Is a Third, Separate Category
Many people lump interest, dividends, and capital gains under “passive income,” but the IRS does not. Federal law explicitly excludes interest, dividends, annuities, and royalties (when not earned in the ordinary course of a trade or business) from passive income, along with gains from selling investment stocks or bonds.5Office of the Law Revision Counsel. 26 U.S.C. 469 – Passive Activity Losses and Credits Limited These items are portfolio income, and they sit outside both the earned and passive frameworks. Practically, that means you cannot use passive losses to offset dividend or interest income.
Why the Distinction Changes Your Tax Bill
Payroll Taxes Hit Only Earned Income
Earned income is subject to FICA payroll taxes of 15.3% — 12.4% for Social Security and 2.9% for Medicare.6Internal Revenue Service. Topic No. 751, Social Security and Medicare Withholding Rates Employees split that with the employer, so 7.65% comes out of their paycheck. Self-employed people pay the full 15.3% as self-employment tax and deduct the employer-equivalent half from gross income.7Office of the Law Revision Counsel. 26 U.S.C. 164 – Taxes
Social Security tax stops at an annual wage base. For 2026, that cap is $184,500.8Social Security Administration. Contribution and Benefit Base Medicare has no cap, and an additional 0.9% Medicare surtax applies to earned income above $200,000 for single filers and $250,000 for joint filers.
Passive and Portfolio Income Face the NIIT Instead
Passive and portfolio income skip FICA entirely because they are not compensation for work. They can face a 3.8% Net Investment Income Tax when modified adjusted gross income crosses these thresholds:9Internal Revenue Service. Net Investment Income Tax
- Single or head of household: $200,000
- Married filing jointly: $250,000
- Married filing separately: $125,000
The NIIT applies to the lesser of your net investment income or the amount your modified AGI exceeds the threshold. These thresholds are not indexed to inflation. Because passive and portfolio income avoid the 15.3% payroll tax and face at most an added 3.8%, a dollar of rental profit or dividends often nets more than a dollar of wages.
Retirement Accounts Require Earned Income
You cannot fund a Traditional or Roth IRA with passive or portfolio income. Your annual contribution is capped at the lesser of your earned income or the IRS dollar limit — $7,500 for 2026 if you are under 50 and $8,600 if you are 50 or older.10Internal Revenue Service. 401(k) Limit Increases to $24,500 for 2026, IRA Limit Increases to $7,500 If your only income is rents, dividends, or interest, you have no earned income and cannot contribute.
The spousal IRA rule is the main workaround. Married couples filing jointly can fund an IRA for a spouse with little or no earned income based on the working spouse’s earnings, as long as combined contributions do not exceed total earned income on the joint return.11Internal Revenue Service. Retirement Topics – IRA Contribution Limits A spouse who runs rentals full-time but earns no wages can still build tax-advantaged savings this way.
Contribute more than your earned income allows and the excess is subject to a 6% excise tax for every year it remains in the account.12Office of the Law Revision Counsel. 26 U.S.C. 4973 – Tax on Excess Contributions to Certain Tax-Favored Accounts and Annuities You can stop the ongoing penalty by withdrawing the excess plus its earnings before your filing deadline, including extensions. Workplace plans like 401(k)s and 403(b)s follow the same earned-income logic and cap total elective deferrals at $24,500 for 2026.10Internal Revenue Service. 401(k) Limit Increases to $24,500 for 2026, IRA Limit Increases to $7,500
Social Security’s Early-Retirement Earnings Test
If you claim Social Security retirement benefits before full retirement age, the earnings test withholds $1 in benefits for every $2 you earn above the annual threshold, which is $24,480 for 2026.13Social Security Administration. 2026 Cost-of-Living Adjustment (COLA) Fact Sheet
Only earned income counts toward that test. Rental income (from activities where you did not materially participate), dividends, and bank interest are excluded from the calculation.14Social Security Administration. What Types of Income Do NOT Count Under the Earnings Test Early retirees can draw substantial passive cash flow without reducing benefits.
The Earned Income Tax Credit
The EITC is available only to filers with earned income. Passive and portfolio income neither qualify you nor count as earned income for the credit’s purposes, and too much investment income disqualifies you outright. For the 2025 tax year, the investment income cap is $11,950.15Internal Revenue Service. Earned Income and Earned Income Tax Credit (EITC) Tables Cross that with combined interest, dividends, capital gains, and rental income, and you lose the credit regardless of your wages.
Maximum 2025 credits range from $664 with no qualifying children to $8,231 with three or more. Phase-outs begin at $23,890 in earned income for single and head-of-household filers and $31,160 for married joint filers. Filers near the investment-income cap should watch the timing of capital gains and dividend payments.
How Losses Behave Differently
Passive losses can generally only offset passive income. When your passive losses exceed your passive income for the year, the excess is suspended and carried forward, not applied against wages. You track this on Form 8582.16Internal Revenue Service. 2025 Instructions for Form 8582 – Passive Activity Loss Limitations Portfolio income also cannot be reduced by passive losses.
The $25,000 Rental Loss Allowance
Federal law carves out an allowance for landlords who actively participate in managing property, meaning they approve tenants, set rents, or authorize repairs. Active participants can deduct up to $25,000 in rental losses against non-passive income each year.5Office of the Law Revision Counsel. 26 U.S.C. 469 – Passive Activity Losses and Credits Limited The allowance shrinks by 50 cents for every dollar of AGI above $100,000 and disappears at $150,000. Married-filing-separately taxpayers who lived with a spouse during the year get $12,500 with the phase-out starting at $50,000. Suspended losses carry forward.
Reclassifying Passive Income as Non-Passive
Business income shifts from passive to non-passive if you materially participate. The IRS provides seven tests, and satisfying any one is enough — for example, more than 500 hours in the activity during the year, or being the person who does substantially all the work.4Internal Revenue Service. Topic No. 425, Passive Activities – Losses and Credits Meeting a test lets you use losses against wages, but income from a trade or business becomes subject to self-employment tax. Keep contemporaneous logs; the IRS frequently challenges material participation, and reconstructed records carry less weight.
Rental real estate is treated as passive by default even when you materially participate. To override that, you must qualify as a real estate professional: more than half of your personal services during the year must be in real property trades or businesses, and you must log more than 750 hours in those activities.5Office of the Law Revision Counsel. 26 U.S.C. 469 – Passive Activity Losses and Credits Limited Real property trades include development, construction, rental, management, leasing, and brokerage. On a joint return, one spouse must meet both requirements alone; you cannot combine hours. Qualifying and materially participating in each rental activity removes the $25,000 cap on rental losses.
One Break Passive Income Keeps: The QBI Deduction
Passive business income, including qualifying rental real estate, can still claim the 20% deduction on qualified business income under Section 199A, which was made permanent by legislation enacted in 2025.17Internal Revenue Service. Qualified Business Income Deduction It applies to income from pass-through entities like partnerships, S corporations, and sole proprietorships, and is available even when the owner does not materially participate.
A rental qualifies if it rises to the level of a trade or business. The IRS safe harbor treats a rental enterprise as qualifying if you maintain separate books, log at least 250 hours of rental services per year, and keep contemporaneous records. Rentals outside the safe harbor can still qualify if they otherwise meet the trade-or-business definition. Portfolio income — dividends, interest, and capital gains — does not qualify.