The Affordable Care Act of 2013 established a Net Investment Income Tax (NIIT) of 3.8% on passive and portfolio income for those who meet certain income thresholds. To avoid this tax on rental or business income, income must be offset by passive losses or be classified as non-passive income. It’s important that business owners understand what distinguishes non-passive and passive activities, and how those activities impact their income reporting and tax obligations.
What is passive versus non-passive income?
Passive and non-passive income are categorized by the business activities that generate them. Passive activities tend to be the hands-off investments (typically through a limited partnership) where an owner is not involved in the day-to-day operations and does not materially participate in the business. Non-passive activities, as you can guess, are just the opposite. The owner normally spends significant time managing/working on typical business activities.
There are nuances to distinguishing between the two activities, but your CPA can help you determine if your business activities pass any of the seven IRS material participation tests for non-passive income. It’s important to keep a record or log book of time spent on business activities if you’re unsure whether it will be passive or non-passive. The easiest test to pass is usually:
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. (Source: IRS, 2023)
The most common examples of non-passive activities that we see at our CPA firm include:
- Oil and gas investments (We are headquartered in Texas!)
- Active management and leadership of the owner’s main business venture, as CEO or other full-time executive
- Short-term rental (STR) income where the average length of stay is less than 7 days, so operations tend to require more time of owners
The most common examples of passive activities that we see at our CPA firm include:
- Investments in limited partnerships
- Real estate investments (when the owner delegates rental management and maintenance)
From a tax standpoint, is passive or non-passive income preferable?
As you can guess, the answer is, it depends. For some taxpayers, passive income may be subject to the additional NIIT mentioned previously. The upside is that passive income can be offset by passive losses (such as those you are carrying forward). Passive losses cannot offset non-passive income, instead they’ll be carried forward to future tax years (if not used to offset other current passive income).
Something we often have to remind clients is that even though portfolio investing is considered a passive activity, portfolio income from interest, dividends, and capital gains are not considered passive income and cannot be offset by passive ordinary losses. This is a separate category of income, which does not factor into the passive/active determination.
How does grouping activities help prove material participation?
Another strategy taxpayers can use if non-passive activities will lower their tax obligation is to group activities. The IRS provides an option to group activities for purposes of passive activity loss limitations (IRS 8582). If a taxpayer has multiple business activities that are similar in nature and fail to pass the IRS material participation tests on their own, a grouping election can treat the activities as one activity which usually helps the combined hours meet one of the material participation tests.
Here’s an example:
Let’s suppose Client XYZ is an LLC with a short-term rental property. The first year of operations, the client has a net loss of about $80,000. The client thought this rental activity loss would be considered passive since they have another entity that is their main focus. The client did not have any other passive income, so the $80,000 of losses would have been disallowed and carried forward to the next year with no tax savings. After going through the 7 tests of material participation, the client realized that they passed the 100 hour and ‘more than any other one person’ test for this property, meaning that the rental activity loss was actually a non-passive activity. The $80,000 of non-passive losses were used to offset other non-passive income leading to a tax savings of about $30,000. If this was a long-term rental, the rules are different and would always be passive unless you are a real estate professional or you can group your rental with an operating business (for example, in a self-rental situation).
Let’s consider this same Client XYZ has another short-term rental property with a $20,000 loss. This activity has to be looked at separately and if they do not meet a material participation test, it will be considered passive. This is when grouping election decisions can be critical. If they group both activities together, can they meet a material participation test? Would they have 500 hours? Or could they satisfy the 100 hour and ‘more than any other one person’ test? There are situations where grouping the two activities can turn both non-passive or can turn both passive.
For business owners with multiple businesses and investments, navigating passive versus non-passive income can be difficult. If you need help analyzing and categorizing your business activities to optimize your tax savings, we can help. Schedule an appointment with our CPAs today.
