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Passive vs Nonpassive Income: What Passive Losses Can Offset

By Hans Goldstein · Updated 2026-09-27

Passive income comes from rentals and from businesses you do not materially participate in. Nonpassive income is everything else: wages, businesses you actively run, and portfolio income such as interest, dividends and investment gains. The distinction matters because passive losses can only offset passive income (§469(a), (d)(1)). A dollar of the wrong kind of income will not free a dollar of your stuck losses.

The three buckets

The tax code effectively sorts your income into three buckets. Only one of them can absorb passive losses.

The statute defines the first bucket. A passive activity is a trade or business "in which the taxpayer does not materially participate," and "includes any rental activity" (§469(c)(1)-(2)). The other two buckets are carved out: earned income "shall not be taken into account" (§469(e)(3)), and portfolio income, "gross income from interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business," is excluded from passive income too (§469(e)(1)(A)).

Why the distinction matters

Your losses carry forward with no expiration (§469(b)), but they only come out against passive income, or when you sell the activity that produced them. So the question "what kind of income is this?" is really the question "will this free my losses?"

A simple example: An investor has $100,000 of suspended passive losses. In one year she sells $100,000 of appreciated stock gain. The losses do nothing: stock gain is portfolio income. The next year she sells a rental with a $100,000 gain. That gain is passive, and the $100,000 of losses can offset it.

Can passive losses offset capital gains?

Yes, if the capital gain is passive. No, if it is portfolio.

Passive capital gain. "Any gain recognized upon the sale, exchange or other disposition ... of an interest in property used in an activity" is passive activity gross income if the activity is passive "for the taxable year of the disposition" (Temp. Reg. §1.469-2T(c)(2)(i)(A)). Selling a passive rental produces passive gain, whether it is taxed as long-term capital gain, unrecaptured §1250 gain or ordinary recapture.

Portfolio capital gain. Gain on property "held for investment" is portfolio income (§469(e)(1)(A)(ii); Temp. Reg. §1.469-2T(c)(3)(i)(D)). That covers stock, bonds, mutual funds and raw land held for appreciation. Passive losses cannot touch it.

Capital losses are a different animal. A capital loss carryforward offsets capital gain of any kind, passive or not, and up to $3,000 of ordinary income a year (§§1211(b), 1212(b)). So a stock-market loss carryforward can shelter rental sale gain, but a rental's passive loss cannot shelter a stock gain.

Can passive losses offset depreciation recapture?

Yes. The regulation says "any gain," and the passive label does not care whether the gain is taxed as ordinary income or capital gain. Section 1245 recapture on cost-segregated components, unrecaptured §1250 gain and long-term capital gain on a passive rental are all passive activity income in the year of sale.

This is one reason released losses can be so valuable at a sale. Because §1(h) taxes ordinary income first, allowed losses reduce the highest-taxed income before they reach the capital gain layer. The layers are in depreciation recapture and unrecaptured Section 1250 gain.

Can passive losses offset ordinary income or W-2 wages?

Not directly. Wages are earned income and never passive (§469(e)(3)). There are only three ways a passive loss reaches wages:

1. The $25,000 allowance for active participants, which phases out between $100,000 and $150,000 of modified AGI (§469(i)). See the $25,000 rental loss allowance.
2. A disposition of your entire interest in the activity in a fully taxable sale to an unrelated buyer, which turns that activity's losses nonpassive (§469(g)(1)(A)).
3. Changing the activity's character, for example a qualifying real estate professional who materially participates, or a short-term rental you materially participate in.

Income that looks passive but isn't

These catch owners and even preparers.

Interest on your installment note

If you sell a rental and carry a note, the gain is passive but the interest is not. Interest on the installment obligation is portfolio income under Temp. Reg. §1.469-2T(c)(3), and the regulations' own example is an installment sale of farmland (§1.469-2T(c)(3)(iv), Example 1). Passive losses offset the gain portion of each payment, never the interest.

Rent from your own business

Net rental income from property you rent to a business in which you materially participate is recharacterized as nonpassive (Reg. §1.469-2(f)(6)), and so is gain on selling that property if it was rented that way within 12 months before the sale (Reg. §1.469-2(f)(9)(iii)). The losses from that property stay passive. See the self-rental rule.

Gain on property that recently was nonpassive

If you materially participated in the activity, or were a real estate professional working the property, within 24 months before signing the sale contract, and the property is worth more than 120% of its basis, the gain can be treated as nonpassive (Reg. §1.469-2(c)(2)(iii)). This is the trap for retired real estate professionals.

Your home

Taxable gain on a personal residence above the §121 exclusion is not passive income. A residence is neither a trade or business nor a rental activity.

Oil and gas working interests

A working interest held without limited liability is nonpassive regardless of participation (§469(c)(3)). Its losses are nonpassive, and once you take a nonpassive loss, later net income from that property is nonpassive too (§469(c)(3)(B)).

Passive vs nonpassive on a K-1

A Schedule K-1 reports your share of the partnership's or S corporation's income, deductions and credits, activity by activity. It does not decide whether they are passive for you. Section 469 applies at your level, based on your participation.

The rules that usually decide it:

• Limited partners are presumed passive. "No interest in a limited partnership as a limited partner shall be treated as an interest with respect to which a taxpayer materially participates," except as regulations provide (§469(h)(2)). A limited partner can only use three of the seven material participation tests (Temp. Reg. §1.469-5T(e)(2)).
• Rental K-1s are passive unless you are a real estate professional who materially participates.
• Portfolio items stay portfolio. Interest and dividends reported on a K-1 are portfolio income even inside a passive partnership.
• Some K-1 income may be nonpassive because of recharacterization rules, such as self-rental income.

Syndication investors will find the full picture in syndication K-1 losses.

How to use the three buckets in planning

1. List your suspended losses by activity. Your Form 8582 worksheets show this.
2. List your expected income by bucket. Wages and investment gains will not help. Rental sale gain will.
3. Match the passive gain to the losses. A sale of a passive rental is usually the largest passive income event you will ever have. If the losses and the gain are different sizes or the gain would land in a high bracket, the timing of the sale matters. That is the waterfall idea.

Bottom line

Only passive income frees passive losses, and the biggest source of passive income most owners will ever see is the gain on selling a passive rental, recapture included. Stock gains, note interest, wages and your home do not count. Know which bucket each dollar falls in before you plan a sale. The Waterfall Strategy is built on this sorting.

Questions to ask your CPA

1. Which of my activities are passive, and which are nonpassive or portfolio?
2. Is any of my rental income recharacterized as nonpassive under the self-rental or 24-month rules?
3. If I sell this rental, how much of the gain will be passive income?
4. Do I have capital loss carryforwards that would offset the gain separately from my passive losses?
5. On my K-1s, which items are portfolio income rather than passive?

Educational only, not tax, legal or investment advice. Examples are illustrative. Have your CPA or tax attorney review your facts before you act. Hans Goldstein is a licensed insurance agent (CA Insurance License #4273294) and is not a CPA or attorney. He is paid a commission only if a structured installment sale is funded; seller financing pays him nothing. Disclosures.