Curated by: Rubric Advisors
Tax Planning
Active Income vs Passive Income
The IRS classifies income as active or passive based on your level of participation, which determines how losses can be used and whether the 3.8% net investment income tax applies.
Active Income vs Passive Income
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Active vs Passive Income, Overview
- Active income comes from work or businesses you materially participate in
- Passive income comes from activities where you do not materially participate
- The IRS uses seven tests to determine material participation status
- This distinction controls how losses are treated and which surtaxes apply
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Full Guide
Active vs Passive Income, Overview
- Active income comes from work or businesses you materially participate in
- Passive income comes from activities where you do not materially participate
- The IRS uses seven tests to determine material participation status
- This distinction controls how losses are treated and which surtaxes apply
What Counts as Active or Passive Income
- Active: W-2 wages, self-employment income, and business income with material participation
- Passive: rental income, limited partnership interests, and businesses you do not actively run
- Guaranteed payments to partners for services are treated as active income
- Certain royalties and licensing income can be classified as passive
IRS Material Participation Tests
- Test 1: 500+ hours of participation in the activity during the year
- Test 2: You did substantially all the work in the activity
- Test 3: 100+ hours and no one else participated more than you
- Tests 4 through 7 cover prior-year participation, personal service, and facts-and-circumstances
Passive Activity Loss Rules
- Passive losses can only offset passive income, not wages or portfolio income
- Suspended passive losses carry forward until you have passive income or dispose of the activity
- A full taxable disposition of the activity releases all suspended losses
- The rules apply to individuals, estates, trusts, and closely held C-corps
The $25K Rental Exception
- Active participants in rental real estate can deduct up to $25,000 in losses against other income
- The exception phases out between $100K and $150K of modified AGI
- Active participation is a lower bar than material participation
- Real estate professionals may deduct unlimited rental losses if they materially participate
Grouping Elections and NIIT
- Taxpayers can group related activities to meet material participation tests collectively
- Once made, grouping elections are generally binding for future years
- The 3.8% net investment income tax applies to passive and investment income
- NIIT kicks in above $200K single or $250K married filing jointly AGI thresholds
Recharacterization and Planning
- The IRS can recharacterize passive income as nonpassive in self-rental situations
- Significant participation activities may be recharacterized if you have net income
- Track participation hours carefully, they determine loss deductibility
- Proper documentation of hours is critical to defend material participation status
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