The Internal Revenue Service has a broad definition of passive income. It is important to point out that passive income can only be generated by passive activities (defined later). Just because you did not work for the income, doesn’t mean that it is passive. There are only two sources of passive income:
· A Rental Activity
· A Business in which a person does not materially participate
Passive income is most commonly reflected as net rental income or as income from a partnership or S-Corporation in which the taxpayer does not materially participate. Some passive income may also be reflected by sales or dispositions of business property as a result of a disposition of a passive activity or asset used in a passive activity. Passive income can also come from certain businesses in which a person does not materially participate.
In my book The Ultimate Guide to Real Estate Investment Taxation, I go into detail on what the difference between active and material participation. Here are the basics:
If you materially participate in a passive activity, the income or loss is treated as non-passive. If you do not materially participate in a passive activity then your income or loss is treated as passive.
Passive income rules state that if you do not materially participate then the income you receive is taxed. If you have a loss from the passive activity, then the loss that you make can only offset other passive income from passive activities.
Generally, income from rental property is treated as passive income. Unless you are a real estate professional, your income, or loss is subject to passive activity rules. Generally, a passive activity in a rental activity is an activity in which a taxpayer does not materially participate.
To qualify as a material participant in a rental activity you must qualify as a real estate professional, and materially participate in the activity as defined in IRC §469(c)(7) . You must satisfy two main tests to qualify under this classification:
1. You must show that more than one-half of the personal services that you performed in your trade or business were performed in real property trades or businesses in which you materially participated in.
2. You must show that you worked more than 750 hours in real property trades or businesses in which you materially participated
Generally most taxpayer fall under the active participation rules when it comes to rental properties. Active participation guidelines are easier to meet than are material participation guidelines. Generally to qualify under the active participation rules, a taxpayer has to make management decisions in regards to the rental property. Management decisions include:
· Approving tenants
· Deciding on rental terms
· Approving capital or repair expenditures
Only individuals can actively participate in rental activities. The exception is that a decedent’s estate is treated as actively participating for tax years ending less than 2 years after the decedent’s death, if the decedent would have satisfied the active participation requirements
Generally, if a taxpayer meets the active participation requirements then they can deduct losses up to $25,000.00. In order to be able to take this deduction the taxpayer must have a modified adjusted gross income (MAGI) of $100,000.00 or less. If a taxpayer’s MAGI were to move over the $100,000.00 threshold, the tax law phases out the $25,000.00 allowance at the rate of 50 cents on the dollar. Using this formula it makes the allowance totally disappear when MAGI hits $150,000.00.
To figure your MAGI, you combine all the amounts on your Form 1040 that you used to calculate your Adjusted Gross Income (AGI) except the following:
· Taxable Social Security
· Deductible contributions to an IRA
· The exclusion from income of interest from qualified U.S. savings bonds used to pay qualified higher education expenses
· Passive income or loss from Form 8582
· The exclusion of income of amounts received from an employer’s adoption assistance program
· Any rental real estate loss allowed because you actively participated in the rental activitiy as a real estate professional
· Any overall loss from a publically traded partnership
· The deduction for one-half of self-employment tax
· The deduction for domestic production activities
· The deduction allowed for interest on student loans
· The deduction for qualified tuition and related expenses
· For more information visit www.smalleynco.com
· If you have any questions you can email Craig W. Smalley E.A.
· Author of the books: It Starts With an Idea – Tax Tips for Small Businesses available on Nook and Kindle, The Ultimate Real Estate Investor Tax Guide, available on Nook and Kindle, The Complete Guide to the New Tax Law – American Taxpayer Relief Act of 2012 available on Nook and Kindle, Everything You Wanted to Know about the IRS – Audits, Appeals and Collections available on Nook and Kindle, Tax Avoidance is Legal! The Complete Guide to Individual Income Tax available on Nook and Kindle, The Complete Guide to the Affordable Care Act’s Tax Provisions available on Nook and Kindle, The Complete Guide to Retirement Plans for Small Businesses available on Nook and Kindle, The Complete Guide to Estate, Gift and Trust Taxation, available on Nook and Kindle, and The Complete Guide to Hiring an Accountant, available on Nook and Kindle.
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