Real estate tax outcomes often hinge on three separate rule sets that people accidentally mix together: (1) passive activity limits (Section 469), (2) the Qualified Business Income (QBI) deduction and (3) the Net Investment Income Tax (NIIT). A small mistake can change whether a loss is usable this year, income qualifies for a potential 20% deduction or if a 3.8% surtax applies, so it’s important to understand each rule to avoid a costly impact. 

Our dedicated Real Estate Tax Consulting Group takes a deep dive into these rules to offer guidance on the best strategic step forward. 

Start with Passive vs. Non-Passive Activity 

Under Section 469, passive losses generally cannot offset non-passive income, such as W-2 wages or active business income. Instead, passive losses are typically suspended and carried forward until you have passive income or dispose of the activity in a qualifying transaction.

Key baseline rule: Most long-term rental real estate is treated as passive by default, even if you spend significant time on it. That default is why the “participation” discussion often needs an extra step (for example, real estate professional status, or a short-term rental exception).

Material Participation: The Seven Tests

You materially participate for the year if you meet any one of these tests:

1. 500-hour test: You participate more than 500 hours during the year.
2. Substantially all test: Your participation is substantially all the participation by anyone (including non-owners).
3. 100 hours and no one else has more: You do more than 100 hours, and no one else participates more than you.
4. Significant Participation Activities (SPA): You have multiple SPAs (each over 100 hours) and the total time exceeds 500 hours.
5. Five of the prior 10 years: You materially participated in the activity for any five of the preceding 10 tax years.
6. Personal service activity: For certain service fields, you materially participated in any three prior years.
7. Facts and circumstances: Based on all facts, you participated regularly, continuously and substantially (with limits—100 hours or less generally will not qualify).

Practical reminders: Spouse participation generally counts for material participation purposes, and investor-type work (monitoring statements, researching markets or portfolio planning) may not count unless it is directly tied to day-to-day operations. Operational work, such as vendor coordination, repairs, guest/tenant issues, scheduling and hands-on management, generally counts.

QBI and NIIT are Separate Questions

QBI asks whether income is from a qualified trade or business (and whether you meet the wage/property limits and other rules). For rentals, many taxpayers look to the IRS rental real estate safe harbor, which can treat a rental real estate enterprise as a trade or business solely for QBI, if requirements are met (including separate books and records, 250 hours of rental services and contemporaneous recordkeeping). Meeting or failing the QBI safe harbor does not decide passive versus non-passive treatment.

NIIT is a 3.8% surtax that can apply when modified adjusted gross income exceeds thresholds. In general, rents are included in net investment income unless they are derived in the ordinary course of a Section 162 trade or business and the activity is nonpassive to you. NIIT has its own definitions and requires a separate analysis.

What Counts as Participation?

In general, operational work counts:

• Managing vendors
• Handling guest/tenant issues
• Doing repairs
• Coordinating cleanings
• Ordering supplies
• Responding to emergencies
• Making day-to-day management decisions

By contrast, investor-type work may not count. Examples include reviewing financial statements, monitoring performance dashboards, researching markets or planning acquisitions, unless those tasks are directly tied to the activity’s day-to-day operations.

Also, hours may be disregarded if the work is not customarily performed by owners and appears designed primarily to generate participation time.

Real Estate Tax Rules in Action

Consider these examples to identify the impact of these rules: 

Long-Term Rentals: Passive by Default

For a typical long-term rental (for example, a 12-month lease), the default result is passive treatment, even if you are hands-on. Investors usually get current-year relief through one of two routes:

1. The $25,000 special allowance (active participation). Taxpayers who actively participate in rental real estate may be eligible to deduct up to $25,000 of rental losses against nonpassive income, subject to income limitations and phaseouts. Active participation is a lower standard than material participation. It generally means making meaningful management decisions such as approving tenants, setting rental terms, and approving expenditures.
2. Real estate professional status (REP) + material participation. If you qualify as a real estate professional, then rental real estate activities in which you also materially participate can be treated as non-passive.

Short-Term Rentals: Often a Different Analysis

Short-term rentals can behave differently because certain short stays can fall outside the definition of a rental activity under the passive activity rules. If the activity is not treated as a rental activity, it is generally analyzed like an operating business. The material participation then becomes the key pivot for passive versus non-passive treatment.

This is why short-term rental planning often focuses heavily on tracking hours, documenting operational tasks and understanding who performed what.

Self-Rentals: A Special Recharacterization Rule

Self-rentals are another common trap (and sometimes an opportunity). If you rent property to a trade or business in which you materially participate, the rules can recharacterize certain net rental income as non-passive. This can be helpful in planning, but it can also surprise taxpayers who expected rental income to remain passive.

Documentation 

Good documentation is often what separates a strong position from an expensive argument later. Credible support can include calendars, emails, platform messages, vendor invoices, task systems, travel or mileage records, and a short narrative describing what you did and why it was operational work.

Important warning: Don’t backfill a time log from memory after you receive an audit notice. If you need to reconstruct, do it carefully from third‑party records (emails, invoices, platform messages, calendar entries, etc.) and label it as a reconstruction. If you are relying on the QBI rental safe harbor, contemporaneous recordkeeping is part of the safe harbor requirements.

Real Estate Tax Rules Overview

Below is a breakdown of the most common real estate situations and how each tax rule may apply. 

Bottom Line

Material participation is powerful, but it doesn’t automatically make long-term rentals non-passive. For many taxpayers, the path to non-passive treatment for long-term rentals runs through real estate professional status plus material participation. Meanwhile, QBI and NIIT require separate analysis: QBI focuses on whether you have a qualified trade or business for Section 199A purposes, while NIIT focuses on whether income is net investment income or excluded because it is derived in the ordinary course of a 162 trade or business and is non-passive to you.