If making money with minimal effort is a financial goal of yours, passive income just might be the answer.
But what exactly counts as a passive activity from a tax standpoint? Let’s look at the different ways the IRS says you can earn passive activity income and how it affects your taxes.
What is passive activity income and why does it matter?
The term “passive income” often brings to mind side hustles touted by influencers as the road to financial freedom. These passive income opportunities are often presented as effortless ways to “get rich quick” or make some extra cash.
On the more technical side, the IRS has strict rules for what qualifies as a stream of passive activity income. These can fall into one of two categories:
- Trade or business activities in which you don’t materially participate during the year
- Rental activities, even if you do materially participate in them (unless you are a real estate professional)
Knowing how to distinguish your passive activity income and deductions from other kinds of activities is important when filing your tax return. Make note that passive activity losses — when your passive activity deductions exceed your passive activity gross income — are generally not allowed. However, there is one important exception to this rule for those who actively participate in rental activities that earn passive income (more on that later).
How to minimize your taxes on passive income
You can use your passive activity losses to offset your passive income. When filing your federal tax return, use Form 8582 to calculate any passive activity losses (PALs) for the tax year.
While you can use passive activity losses to offset profits from other passive activities, you can’t deduct PALs against nonpassive income. If you’re unsure about what counts as a passive income stream, use the IRS material participation tests we discuss later to determine if you meet the passive activity parameters.
How do I report passive activity losses and credits on my tax return?
There are two forms you can use to report passive activity income and losses on your federal income tax return:
- Form 8582: Use this form to list your passive activity income and losses and determine which losses are deductible.
- Form 8582-CR: Use this form to list and determine any passive activity credits.
Active income vs. passive income: What types of income meet the IRS passive activity rules?
For an income stream to be considered passive by the IRS, it should fall into one of the following categories.
1. Rental activities
Example of passive income rental activity: You purchase a condo or duplex and rent it out to single-family tenants. The net rental income you collect on this property is considered a passive activity.
However, there are a few caveats. These caveats include, but are not limited to:
- If you qualify as a real estate professional, your rental income is considered active income, not passive.
- The IRS specifically calls out rental units that you also use for personal purposes during the year — think someone who rents out their property on Airbnb or VRBO but also lives in the property for part of the year. For this type of income to be considered a passive activity, you cannot use the property for personal purposes for more than the greater of 14 days or 10 percent of the days you rent it during the year.
Example of a nonpassive rental activity: You rent out a property on Airbnb about 180 days out of the year. You also use this property as a personal vacation home for 30 days of the year. Because you used the property for more than 18 days (10 percent of 180 rental days), it is not considered a passive activity, and you would not be able to apply any losses on this rental against your other income.
To be considered a passive activity in this example, you would not be able to use the property as a personal vacation home for more than 18 days. If, say, you only personally used the home for 17 days and actively participated in managing the property, you may be able to apply rental activity losses (up to $25,000) against sources of nonpassive income.
2. ‘No material participation’ activities
To be considered a passive activity, you cannot materially participate in the activity during the year. To help you determine this, the IRS lists seven “material participation tests.”
For a tax year, you are considered to have materially participated if you can say yes to any of the following tests:
- Did you participate in the activity for more than 500 hours?
- Did your participation in the activity comprise a substantial part of all the participation in the activity during the year?
- Did you participate in the activity for more than 100 hours during the year and at least as much as any other person involved?
- Did you participate in multiple activities for more than 100 hours each during the year, and did your participation in all such activities exceed 500 hours when combined?
- Did you materially participate in this activity for any 5 of the past 10 tax years?
- Did you materially participate in this activity for any 3 of the past 10 tax years, and is the activity a personal service activity that involves your personal time and effort? Examples include health and veterinary services, consulting, performing arts, law, accounting, engineering, architecture, and actuarial science.
- Did you participate in the activity on a regular, continuous, and considerable basis? To materially participate under this test, you must participate in the activity for at least 100 hours while no other person received compensation for managing the activity, and no other person spent more hours managing the activity than you did (regardless of whether they were compensated or not).
Example of a passive income activity with no material participation: You purchase a business and hire someone else to run it for you. You do not help manage the company or participate in the business operation, but you receive a percentage of all business earnings.
3. Self-charged interest
According to the IRS, if you loan money to a pass-through entity that you own (such as a partnership or S corporation), the interest income earned on the loan can qualify as passive income if the loan proceeds are used in a passive activity. This is also true the other way around — when your S corp or partnership collects interest on a loan made to you.
However, if the partnership were involved in passive and nonpassive activities, the interest income you earn would also need to be allocated between passive and nonpassive income.
Example of self-charged interest passive income: You are an owner of a manufacturing S Corp that rents out part of its building to a third party. You make a loan to your S Corp to build the building and collect interest from the loan payments. Since the corporation is engaged in a passive activity (rental real estate) and a nonpassive activity (manufacturing), the interest income would need to be split between passive and nonpassive income on your taxes.
Passive activity recap
The IRS has strict rules regarding what it considers passive activities, including earnings from certain rental activities or business activities in which you are not actively involved. But if you do meet the passive activity parameters, you can deduct your passive activity losses against your passive income on your tax return.
This article is for informational purposes only and not legal or financial advice.