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.
The IRS has specific definitions for passive income
“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)
There are 7 “material participation” tests
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.
- You participated in the activity for more than 500 hours.
- Your 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.
- You 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 you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you 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.)
- You 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 you 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, you 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.
Real estate activities are usually passive
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” above, 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 [they] materially participated.”
Airbnbs income could be reported on Schedule C or Schedule E
As temporary rentals like Airbnb and VRBO increase in popularity, one of the most common questions you may get is “Is my Airbnb considered passive income?” The answer? It depends.
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.
Spouses’ activity counts towards material participation
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 losses can only offset passive income
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.
For more information, see our post on Understanding Passive Loss Limitations.
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).
The passive income tax rate is usually based on tax bracket
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.
If your client’s questions above so-called “passive income” were really about portfolio income like stock investments, you can find answers in The Tax Preparer’s Guide to Reporting Stock Investments.