Passive activity income is income that requires little to no actual work to earn and maintain. It is referred to as progressive passive income when the person who earns it puts little to no effort into their passive activity to increase the income.
Examples of passive income may include rental income and business activities in which a person does not participate to any significant degree. For example, the person may be an investor in a business enterprise. The U.S. Internal Revenue Service (IRS) distinguishes passive income from other forms of income, such as income earned from regular employment, and taxes it differently.
The IRS categorizes income into active, passive, or portfolio income. Passive income comes from two sources, or passive activities, only, either “rental activity” or “trade or business activities,” in which a person does not participate substantially. Other financial and government institutions also recognize passive income as income obtained through capital growth or negative gearing. (Negative gearing is not discussed in this article.)
The IRS taxes passive income in most cases. The main tax issue is whether expenses and losses from passive activity can be deducted from other income not derived from a passive activity.
Passive activities include trade or business activities in which a person does not “materially participate.” Material participation in an activity means that a person is involved in the operation of the activity on a “regular, continuous, and substantial basis.”
In general, rental activities, including rental real estate activities, are also passive activities even if a person materially participates. However, a person’s material participation in real estate rental activities is not passive if the person involved qualifies as a real estate professional.
Generally, any loss from passive activity disallowed in a prior tax year may be deducted in full in the year in which the taxpayer disposes of their entire interest in the activity.
What Types of Passive Activity Income Are There?
Again, the IRS recognizes two kinds of passive activities, i.e., trade or business activities in which a person does not materially participate, and rental activities, whether or not a person participates materially.
To Whom Do Passive Activity Restrictions Apply?
Differentiating passive and active income is important for several reasons, one of which is that a taxpayer can claim a passive loss only against income generated from passive activities. A taxpayer cannot claim a passive loss against active or portfolio income.
This passive activity restriction applies to:
Again, rental real estate activities in which a person participates materially are not passive if the person involved is a real estate professional.
Can I Take a Tax Deduction for a Passive Activity Loss?
In general, passive activity losses can only offset passive activity income, and passive activity tax credits can only be used against tax attributable to passive activity income on a person’s tax return.
For example, rental activity is considered “passive” activity. A loss on a passive activity is not deductible against non-passive income, such as income earned in wages or salary.
A special rule, however, allows a person to deduct up to $25,000 of losses from rental real estate in which a person actively participates. This deductible amount decreases as the taxpayer’s income increases, and ultimately the exception to the passive activity rule phases out. The exception decreases as a taxpayer’s modified adjusted gross income (MAGI) rises above $100,000 and is completely disallowed when their MAGI exceeds $150,000.
In addition, disallowed passive activity expenses and losses not used in one year can be carried forward to offset future passive activity income. In the year that the taxpayer disposes of their entire interest in the passive activity, any remaining passive activity losses that have been carried over generally may be used as a deduction against the taxpayer’s other income.
Of course, taxpayers may avoid the unfavorable treatment for expenses and losses associated with a passive activity if they materially participate. Then the income is no longer passive and becomes active. As expenses and losses related to regular business activity, the expenses and losses would receive more favorable treatment under the tax code.
What Is a Hobby Loss?
A hobby loss is a loss incurred from pursuing a hobby or other activity in that a person does not pursue profit. A person cannot claim expenses for a hobby that exceed the amount of the total hobby income that the person reports for a tax year.
When Can I Take a Deduction for a Hobby Loss?
Again, taxpayers can generally only deduct hobby expenses and losses up to the amount of hobby income. If hobby expenses are more than the income realized from a hobby, taxpayers have a loss from the activity. However, a hobby loss cannot be deducted from income from other business activities or employment. In other words, hobby losses can only be deducted from hobby income.
So, if a person is a painter who only rarely sells a painting, they cannot deduct the costs of their oil paints, canvases, and picture frames from their income, other than any income they earn from picture sales, on their tax returns.
How Do I Prove a Profit Motive for My Hobby or Second Business?
As noted above, the deductible expenses of a hobby are limited to the amount of income the hobby generates. This limitation can be avoided, and a hobby can be considered a business if the hobby is engaged in for profit.
If a person has made a profit on their second business or hobby activity in three of the last five years, they are presumed to have a genuine profit motive. The IRS also looks at several other factors to determine if a person is engaged in a second business or hobby with a profit motive. These factors include whether the person:
- Maintains a separate bank account for business;
- Has a name for their business;
- Keeps a set of books;
- Has a business license;
- Has a separate area of their home in which they conduct their business activity;
- Has a separate phone and fax line for business;
- Has letterhead stationery and business cards;
- Has a business plan;
- Advertises, markets, or promotes their business;
- Spends time each day or week on their business;
- Tries new avenues for advertising and marketing their business;
- Meets with customers and clients each week;
- Makes a reasonable effort to make a profit in the same way as other people do in the same business;
- Experiences losses due to circumstances beyond their control;
- Has a track record of past profitable ventures;
- Has had a profit in any previous years;
- Has losses that are getting smaller each year;
- Has a reasonable level of expertise in this area;
- Depends on income from the activity to live on.
No one factor alone would determine the outcome in any given case. Rather, a court would look at the entire situation to determine.
Should I Contact a Lawyer?
With the variety of tax software programs available, many people are capable of doing their taxes on their own. But characterizing income and losses and determining whether or not loss deductions are limited to certain income on your return may require consultation with an expert tax attorney.
For example, you would not want to lose a potential deduction of as much as $25,000 from your rental activity. It could make a big difference to your financial situation to avoid paying taxes you do not have to pay. So you should consult a qualified tax attorney.
Additionally, should you have a dispute with the IRS or your state taxing authority regarding your loss deductions, you may need to go to court, where you will certainly need the assistance of an experienced tax attorney.
