Passive income streams are becoming more and more common. As people turn to passive income activities to help support their families financially, they’re often left wondering how these businesses will affect how and when they do their taxes. We’re covering the essentials so that you can confidently guide your clients with passive income through the process of filing taxes.
Key takeaways on passive income and taxes
- The IRS defines passive income as activities where the taxpayer does not materially participate, such as limited partnerships or rental activities (unless the taxpayer qualifies as a real estate professional). It’s important to distinguish passive income from portfolio income, such as stock investments.
- Passive income is generally taxed at the taxpayer’s marginal tax rate, similar to active income. However, those with a modified adjusted gross income above a certain threshold may be subject to the Net Investment Income Tax (NIIT) of 3.8%.
- To determine whether income is considered passive or active, the IRS outlines specific “material participation” tests.
- While passive income and active income are typically taxed the same, long-term capital gains and qualified dividends have special tax rates that are usually lower.
What does “passive income” mean?
“Passive income” is often used colloquially to define anything from stock investments to blogging. But the IRS has specific parameters for passive income activity. For tax purposes, true passive income activities are either 1) “trade or business activities in which you don’t materially participate during the year” or 2) “rental activities, even if you do materially participate in them, unless you’re a real estate professional.”
So while stock investments may be casually referred to as “passive income,” they are actually considered “portfolio income” by the IRS. In line with the definition above, true passive income is usually one of the following:
- Limited partnerships with some exceptions (i.e. a partnership where your client has invested in the business but does not participate in running it)
- Partnerships, S-Corporations, and limited liability companies in which the taxpayer does not materially participate
- Equipment leasing
- Rental real estate (unless the taxpayer qualifies as a real estate professional)
- Sole proprietorship or farm in which the taxpayer does not materially participate
Some less common examples of passive income include:
- Gain from disposition of property used in a passive activity
- Gain from disposition of an interest in a passive activity
- Self-charged interest (i.e. the money is loaned from one of your personal accounts to a passthrough business that you own or are a partner in. An exception is if the passthrough entity made an election under 26 CFR Sec 1.469-7)
What is the tax rate on passive income?
Typically, passive income is subject to a taxpayer’s usual marginal tax rate, which is based on their tax bracket.
But taxpayers whose modified adjusted gross income is above a certain threshold may also be subject to the Net Investment Income Tax (NIIT). This 3.8% tax applies to certain types of income, including income from passive activities.
Passive income and active income are generally taxed the same way. However, there are special tax rates for long-term capital gains and qualified dividends, which are usually lower and more beneficial.
If your client’s questions about so-called “passive income” are really about portfolio income like stock investments, you might want to explore resources to clarify any concerns they have about investment reporting.
Understanding “material participation” tests for passive income
Determining whether your client materially participated in an activity can be tricky – but it’s critical to deciding whether income should be taxed as active or passive income. For this reason, the IRS offers very specific guidelines on material participation. If your client meets any of the following 7 guidelines listed in IRS Publication 925, they did materially participate, and the activity would not be considered a passive income activity:
- Your client participated in the activity for more than 500 hours.
- Their participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
- They participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
- The activity is a significant participation activity, and your client participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which they participated for more than 100 hours during the year and in which they didn’t materially participate under any of the material participation tests, other than this test. (Not sure what counts as “significant participation activity”? You can find a list of “Significant Participation Passive Activities” in IRS Publication 925 under the “Recharacterization of Passive Income” section.)
- Your client materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
- The activity is a personal service activity in which they materially participated for any 3 (whether or not consecutive) preceding tax years. (See Publication 925 for definition of An activity is a “personal service activity”).
- Based on all the facts and circumstances, your client participated in the activity on a regular, continuous, and substantial basis during the year.
If your client meets one of these seven tests, they should treat the activity as “nonpassive” instead of passive. Make sure that you correctly report them on Schedule E (Form 1040), which has separate lines for passive and nonpassive income and losses. For tax purposes, “Your participation in an activity includes your spouse’s participation. This applies even if your spouse didn’t own any interest in the activity and you and your spouse don’t file a joint return for the year.”
Passive income from real estate activities
It’s worth noting again that real estate activities are often an exception to the material participation rule. In most cases, even if your client does meet one of the material participation tests, the activity will still be considered passive unless they are a real estate professional.
To qualify as a real estate professional, your client must meet both of the following requirements:
- More than half of the personal services they performed in all trades or businesses during the tax year were performed in real property trades or businesses in which they materially participated.
- They performed more than 750 hours of services during the tax year in real property trades or businesses in which theymaterially participated.
In addition to understanding passive income, it’s important for your clients to be aware of deductions available for real estate income. These can include mortgage interest, property taxes, maintenance and repair costs, insurance, and depreciation. To claim these deductions, your clients should maintain detailed records of all expenses related to their real estate activities.
Are Airbnb and other rental properties considered passive income sources?
As temporary rentals like Airbnb and VRBO increase in popularity, many property owners find themselves wondering whether these rental properties can be considered passive income sources. The answer varies depending on several factors, including the level of involvement in managing the property. If the average rental period was less than 7 days, and your client provided “significant services” such as housekeeping services, coffee and coffee maker, linen services, or other “hotel-like services,” then the Airbnb is being treated as a business. It should be reported on Schedule C and will be subject to the self-employment tax.
On the other hand, if your client does not provide any significant services at their Airbnb, it can likely be classified as a real estate rental and reported on Schedule E, especially if the average rental period was longer than 7 days. In this case, the income is considered passive and is not subject to the self-employment tax.
Can passive losses offset passive income?
A passive loss refers to a financial loss resulting from passive activities. If your client’s passive losses exceed their passive income for the year, they typically cannot deduct the entire loss from their taxable income. For example, if they had $16,000 in income from rental real estate properties but $20,000 in losses, they can only deduct the $16,000 for the current year. The remaining $4,000, however, can be carried forward to future tax years to offset passive income.
You can group multiple activities into one activity for tax purposes
The IRS allows multiple trade, business, or rental activities to be grouped into a single activity if they form “an appropriate economic unit.” An appropriate economic unit can be based on a variety of factors, including:
- the similarities and differences in the types of trades or businesses
- the extent of common control
- the extent of common ownership
- the geographical location
- and the interdependencies between or among activities.
Grouping activities can have a variety of benefits, one of which is that your client will only have to prove material participation for one of the grouped activities instead of for each one. If the IRS disagrees with your groupings, they may regroup them and recalculate taxes accordingly. For more information on how you can group activities to provide the most benefit for your client and how to appropriately disclose those groups, refer to Publication 925.
Note that trade and business activities can be grouped together, and rental activities can be grouped together, but trade or business activities can usually not be grouped with rental activities except in a few special circumstances.
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