Passive vs. Active Income and Losses: Understand the Differences to Avoid Costly Surprises
Understanding how the IRS distinguishes between active and passive business activities is an important consideration for business owners and investors. Failure to make the proper distinction can lead taxpayers to misclassify the business income or losses resulting from such activities, an error that can have significant tax consequences.
The Difference—and Why It Matters
The distinction between active and passive activities matters because passive income and losses are subject to very different tax rules than income or losses from a business in which a taxpayer is actively engaged. To cite the most basic example, income from salary or wages is subject to Social Security and Medicare taxes, while income from passive partnerships or rental properties generally is not. But that is just the beginning.
For taxpayers whose adjusted gross income exceeds $200,000 ($250,000 for married filing jointly), passive income can be subject to an additional 3.8% net investment income tax (NIIT). This tax is not imposed on income that is generated by an activity in which a taxpayer is an active participant. Another significant difference involves taxpayers’ ability to deduct any losses they might incur from passive business activities.
Classifying Losses—a Critical Concern
The distinction between active and passive activities directly affects how business losses are reported and used. In fact, it was the excessive use of business loss deductions in the 1980s that led Congress to create the special passive activity rules that are now in effect. To prevent high-income individuals from avoiding taxes by claiming large paper losses from real estate investments and other tax shelters, current tax law states that, in most cases, passive losses can be used only to offset income from other passive activities.
In other words, a taxpayer cannot use losses from passive investments, such as real estate or limited partnerships, to offset salary or profits from a business in which the taxpayer is actively participating. Any unused passive losses can be carried forward, but even in future years they can be used only to offset other passive income until such time that the activity is sold. Misunderstanding these passive loss rules and incorrectly classifying taxable income or losses can lead to serious penalties.
Passive Income and Losses—a Closer Look
As explained in IRS Publication 925, “Passive Activity and At-Risk Rules”, the IRS recognizes two types of passive activities:
- Any trade or business activity in which the taxpayer does not materially participate
- All rental activities (with some exceptions)
For the first type of passive activity, the IRS spells out a list of seven tests that qualify as “material participation.” Common examples include participating in the business for more than 500 hours during the tax year or participating for at least 100 hours and doing more than any other individual.
A taxpayer who meets any of the seven tests is considered a material participant. This means that activity is classified as active, not passive, so any losses resulting from that business may be deducted against other active income.
By default, the tax code classifies all rental activities as passive, but there are some exceptions. For example, income from short-term vacation rentals may be classified as active if the average rental period is seven days or less and the owner meets one of the material participation tests. Read more here: Think Twice Before Joining the Short-Term Rental Trend
Another exception is made for taxpayers who spend more than half of their working time in a real estate–related trade or business and who work more than 750 hours per year in that business. The tax code characterizes such taxpayers as “real estate professionals,” which means they may be able to avoid incurring the NIIT on rental income and could potentially use any rental-related losses to offset other active income. Read more here: Qualifying as a Real Estate Professional
In some instances, property owners who are not real estate professionals could be allowed to deduct up to $25,000 in passive rental losses against active income, provided they actively participate in management decisions such as approving tenants, deciding on rental terms, and approving expenditures. This special allowance starts phasing out for taxpayers with adjusted gross incomes over $100,000 and phases out completely at $150,000.
Practical Impacts
Distinguishing between active and passive activities is not just an abstract concept, it directly affects how business losses are reported and whether owners can benefit from them. For example, tax shelters that promise large tax write-offs are often less valuable than they first appear because they are passive investments and thus cannot be used to offset a taxpayer’s salary or other active income. The classification of activities can also impact tax planning, ownership structuring, income shifting among family members, and other critical investment decisions.
As in all tax-related matters, accurate record-keeping and thorough documentation are essential to ensure business activities are properly classified and to prove that in the event of an audit. The passive activity rules are complex, with detailed exceptions and carve-outs. Before buying property, joining a business, or investing in any tax-saving opportunity, it is vital to consult with a professional tax advisor first.
Please contact us if you have questions about income and loss classification.
