Passive vs Non-Passive Income and Cost Segregation

IRC Section 469 organizes income and losses into three distinct categories: active (non-passive), passive, and portfolio. Portfolio income includes dividends, interest, royalties, and capital gains from investment assets. Active income includes wages, self-employment income, and income from businesses in which the taxpayer materially participates. Passive income includes income and losses from activities in which the taxpayer does not materially participate, plus all rental income by default.

Losses can only offset income in the same category. Passive losses cannot reduce active income or portfolio income. Active losses cannot reduce passive income. Portfolio income generally cannot be sheltered by either type of loss. This three-bucket framework is the foundation of the passive activity rules.

For most real estate investors, cost segregation generates passive losses. This is not because cost segregation itself is passive, but because rental activities are passive by statute under Section 469(c)(2). Rental income and rental losses, including depreciation deductions generated by cost segregation, are automatically classified as passive unless the taxpayer meets the real estate professional exception.

This means that without REPS qualification, even an investor who spends hundreds of hours annually managing their properties and performing physical maintenance has passive losses from cost segregation that cannot offset wages. The automatic passive classification of rental activities is not overridden by the amount of time spent; only the specific statutory tests override it.

The passive versus active real estate classification for a given taxpayer in a given year depends on two determinations:

• Whether the taxpayer qualifies as a real estate professional under the 750-hour and more-than-half tests
• Whether the taxpayer materially participates in each rental activity for which non-passive treatment is sought

If the taxpayer satisfies both, the rental activity is non-passive. If either test fails, the rental activity is passive. The determination is made annually and independently for each tax year. A taxpayer who qualified as a real estate professional in prior years does not carry that status into the current year automatically.

When a real estate professional treats rental activities as non-passive, the income from those activities is also non-passive. This has an important implication: non-passive rental income cannot be sheltered by passive losses from other activities.

An investor who qualifies for REPS may have both non-passive rental income from qualifying activities and passive losses from other investments. Those passive losses cannot offset the non-passive rental income. The two buckets remain separate in both directions.

This is relevant for real estate professionals who have some properties generating income and others generating losses. If both sets of properties are in the non-passive bucket (because both satisfy material participation and REPS applies), the income and losses net against each other directly. If some properties remain passive (because material participation was not satisfied for those specific assets without a grouping election), the passive income from those properties can absorb passive losses from passive activities but not non-passive losses.

Material participation is what distinguishes a non-passive trade or business from a passive one. For businesses other than rental activities, material participation alone is sufficient to make the activity non-passive. For rental activities, however, material participation is necessary but not sufficient. The taxpayer must also qualify as a real estate professional.

This additional requirement for rental activities is the statutory anomaly that makes real estate professional status so important for property investors. No amount of material participation converts rental losses to non-passive without the REPS gateway qualification being satisfied first.

Real estate professional status removes the automatic passive designation from qualifying rental activities. Once the designation is removed, each rental activity is treated like any other trade or business activity, and material participation determines passive versus non-passive classification.

This is the precise mechanism through which real estate professional status converts cost segregation losses from deferred passive carryforwards into immediate deductions against ordinary income. The REPS qualification does not create the deduction; it changes where the existing depreciation deduction is allowed to flow.

On Form 1040, passive income and non-passive income from rental activities both flow through Schedule E. Non-passive income and losses flow through directly and affect adjusted gross income without any Form 8582 limitation. Passive income and losses are filtered through Form 8582, which applies the passive activity loss limitation and calculates the allowable deduction and the suspended loss carryforward.

The Schedule E for a real estate professional with all non-passive rental activities will show the full income or loss from each property flowing directly to Form 1040. The Schedule E for a passive investor with the same properties will show losses as limited by Form 8582, with the excess suspended.

Investors who cannot qualify for REPS can still absorb passive cost segregation losses through passive income from other sources. The most common passive income sources for real estate investors include:

• Net rental income from other properties not generating cost segregation losses
• Income from limited partnership interests where the investor does not materially participate
• Distributions characterized as passive income from real estate funds or syndications
• Gain from the sale of passive activities (before the suspended loss release offset)

Strategic allocation of passive income sources alongside cost segregation properties is the primary planning tool for investors who are not real estate professionals and want to extract current value from passive depreciation losses.

The passive activity rules create a two-way limitation that is often misunderstood. Not only can passive losses not offset non-passive income, but passive losses also cannot offset portfolio income such as dividends, interest, and capital gains from investment securities. And non-passive losses cannot shelter passive income from rental activities.

This creates a scenario where a real estate professional with a large non-passive loss from a cost segregation property cannot use that loss to shelter passive rental income from a property in which they do not materially participate. Each activity is classified independently, and losses flow only to income of the same classification.

An investor may have cost segregation studies on multiple properties, some non-passive (qualifying REPS activities) and some passive (activities where material participation is not satisfied). Each property's depreciation flows according to its own classification. The total picture on Schedule E may show a mix of non-passive losses (reducing AGI directly) and passive losses (subject to Form 8582 limitations).

Planning the allocation of cost segregation engagements across a portfolio, in the context of the passive versus non-passive classification of each property, is a meaningful advisory function for high-volume real estate investors. For the detailed mechanics of why this matters for cost segregation strategy, and how to evaluate the study economics under each scenario, the broader cost segregation framework provides the relevant context.

For investors who are approaching or evaluating the REPS qualification threshold, the analysis of what counts toward the 750-hour test and the companion guide on how to satisfy material participation for each rental property are the two resources most directly relevant to converting passive losses into non-passive deductions through REPS qualification.