When it comes to taxes, not all income and losses are created equal. One of the most important distinctions real estate investors need to understand is the difference between passive and nonpassive activities. It’s a foundational concept that can either unlock powerful tax savings or leave you sitting on unused losses year after year.
In this blog, we’ll break down what these terms mean, why they matter, and how material participation plays a central role in shaping your tax outcome.
What the IRS Says: Passive vs. Nonpassive
The IRS separates all income and losses into two main buckets: passive and nonpassive. This distinction is defined under Section 469 of the Internal Revenue Code.
Passive activities include rental real estate (by default) and businesses where you don’t materially participate. Losses from these activities are limited. They can only be used to offset other passive income or be carried forward to future years.
Nonpassive activities are those where you materially participate or qualify as a real estate professional. These activities allow for much more flexibility. Losses from nonpassive activities can be used to offset W-2 wages, business income, capital gains, and any other type of income on your return.
Understanding which bucket your activity falls into isn’t just semantics. It determines how much of your real estate losses you can deduct at tax time.
Rental Real Estate Is Passive by Default
The IRS automatically considers rental real estate to be passive. That means unless you take specific action to change its classification, you’ll be limited in how you can apply any losses it generates.
There are two main ways to shift rental real estate from passive to nonpassive:
- Materially participating in a short-term rental activity
- Qualifying for real estate professional status (REPS)
Without one of these exceptions, your losses remain locked in the passive bucket.
This default classification creates a significant limitation. You could have a considerable loss from a property but be unable to deduct it against active income because it doesn’t meet the nonpassive criteria.
How to Make an Activity Nonpassive: Focus on Material Participation
The key to unlocking nonpassive treatment is material participation, which is also defined under IRC Section 469.
The IRS outlines seven tests to determine material participation, but most real estate investors rely on one of these two:
- You spend 500 or more hours on the activity during the year
- You spend 100 or more hours, and more than anyone else involved in the activity
If you meet one of these, your activity may be considered nonpassive, which opens the door to much broader tax strategies.
REPS requires additional criteria beyond material participation be met in order to qualify:
- You spend more than 50% of your time on real estate trades or businesses in which you materially participate
- You spend more than 750 hours in real estate trades or businesses in which you materially participate
This is especially important if you’re trying to use strategies like cost segregation or bonus depreciation. If your activity is still passive, the loss created by these strategies may be stuck and offer little to no benefit right now.
Documentation matters. Tracking your time and showing how you participated is a key part of making your case. This becomes especially important if the IRS asks for proof down the road.
Tax Strategy Starts with the Right Classification
Material participation is the starting point of what makes all the best tax strategies work.
If your real estate activity remains passive, you could run a cost segregation study and generate a six-figure loss that you might not be able to immediately benefit from. The loss sits in your passive bucket until you have passive income to offset it.
If that same activity is nonpassive, the loss becomes much more powerful. It can reduce your overall taxable income and offset high-earning W-2 wages and business income.
This is why Aiola CPA focuses on proactive planning. We help you structure your time and your records so you’re not just hoping a strategy works. You’re making sure it will.
Common Mistakes to Avoid
1. Acting before consulting a tax professional
Too many investors buy a property before confirming whether they can actually deduct the losses.
2. Misunderstanding what counts as participation
Not all hours are equal. Only certain types of work count toward the material participation tests. Records must also be audit-ready.
3. Confusing “being active” with “nonpassive”
Just because you’re involved doesn’t mean the IRS agrees. Material participation requires specific thresholds, not just general involvement.
4. Misapplying tax strategies
Strategies like cost segregation and bonus depreciation only work the way you expect if the activity is nonpassive. Otherwise, you’re just generating paper losses that may not be usable anytime soon.
Final Thoughts
Passive vs. nonpassive is not just a tax label. It is the framework that determines whether your real estate investments help you at tax time or create unused deductions.
Understanding where you stand and what actions can shift your activity into the correct category is one of the most powerful steps you can take as a real estate investor.
Need help reviewing your situation? Let’s talk strategy.
At Aiola CPA, we specialize in tax planning for real estate investors. We’ll help you clarify your current position and build a plan that works in real life, not just on paper.
