Passive income broadly refers to money you don't earn from actively engaging in a trade or business. By its broadest definition, passive income would include nearly all investment income, including interest, dividends, and capital gains. What most people are referring to when they talk about passive income is income that comes from what the IRS calls a passive activity.

Passive activity income often gets very different tax treatment from the ordinary income that people have. In particular, passive losses are typically deductible only against passive income, and you're not able to claim excess passive losses immediately, instead having to carry them forward. It's therefore vital to understand the tax rules surrounding passive activity income in order to assess investments in passive activities correctly.

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What is a passive activity?

The IRS defines passive activities as any business in which the taxpayer doesn't materially participate or any rental activity. It specifically excludes portfolio and investment income from the definition of passive activity income.

The key here is that income from equipment leasing or rental real estate is generally treated as passive income, with only limited exceptions. Other businesses, including sole proprietorships, partnerships, limited liability companies, and S corporations, produce passive income if the individual taxpayer in question doesn't meet the standard for material participation.

What's material participation?

Material participation is a test that the IRS provides. There are several ways to meet the standard:

  • Working in the activity for more than 500 hours during the year
  • Being the sole participant in the business for the year
  • Working at least 100 hours and as much as any other individual at that business during the year
  • Working at least 100 hours in that activity and a total of more than 500 hours at all passive activities
  • Material participation in at least five of the past 10 tax years
  • For personal services businesses, material participation in three previous tax years at any time

Finally, a facts and circumstances test allows for consideration of whether you engaged in regular, continuous, and substantial participation during the year, but with the requirement of working at least 100 hours.

What counts as work for these purposes can get complicated, but in general, it refers to the work that a business owner would typically do. Work that you'd do as an investor is limited to those involved in day-to-day management of the business.

How do real estate passive activities get taxed?

Rules for real estate activities differ. You can only treat rental real estate as an active business if you meet stricter tests to be a real estate professional, which requires at least 750 hours of service and more than half of all personal service you provide to be in the real estate category.

Those who don't meet this test can qualify for a limited $25,000 allowance for losses if they qualify as an active participant. Active participation requires only limited activities, such as approving new tenants, setting rental terms, and approving payouts. If you qualify, you can then take up to that limited amount of loss each year, carrying over any excess losses until you generate rental income to offset it.

Goal: Promoting profitable business activity

In general, the purpose of the passive activity rules is to prevent taxpayers from improperly claiming immediate tax losses on investments. Instead, the IRS wants to limit loss deductions to those businesses where taxpayers were integrally involved with the operation or management of the business. In conjunction with other rules that limit losses to the amount of money that an investor puts at risk, the end result of the passive activity rules is to encourage taxpayers to engage in profitable passive activities in order to wipe out any passive activity losses they might incur.

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