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What is 'Passive Income'

Earnings an individual derives from a ren​tal propertylimited partnership or other enterprise in which he or she is not materially involved. As with non-passive income, passive income is usually taxable; however it is often treated differently by the Internal Revenue Service (IRS). Portfolio income is considered passive income by some analysts, in which case dividends and interest would be considered passive.

BREAKING DOWN 'Passive Income'

There are three main categories of income: active income, passive income and portfolio income.

Passive income has been a relatively loosely used term in recent years. Colloquially, it’s been used to define money being earned regularly with little or no effort on the part of the person who’s receiving it. Proponents of earning passive income tend to be boosters of a work-from-home and be-your-own-boss professional lifestyle. The type of earnings people usually associate with this are gains on stocks, interest, retirement pay, lottery winnings, online work, and capital gains.

While these activities fit the popular definition of passive income, they don’t fit the technical definition as outlined by the IRS. 

Passive income, when being used as a technical term, is defined as either ‘net rental income and income from a business in which the taxpayer does not materially participate’, and in some cases can include self charged interest. 

Self Charged Interest

When money is lent to a partnership or S-corporation acting as a pass-through entity (essentially a business that is designed to reduce the effects of double taxation) by that entity’s owner, the interest income on that loan to the portfolio income can qualify as passive income. As the IRS language reads, ‘Certain self-charged interest income or deductions may be treated as passive activity gross income or passive activity deductions if the loan proceeds are used in a passive activity’. 

Property

Rental properties are defined as passive income with a couple of exceptions. If you’re a real estate professional, any rental income you’re making counts as active income. If you’re ‘self renting’ meaning that you own a space and are renting it out to a corporation or partnership where you conduct business, that doesn’t constitute as ‘passive income’ unless that lease had been signed before 1988 in which case you’ve been grandfathered into having that income being defined as passive. According to the IRS, ‘it does not matter whether or not the use is under a lease, a service contract, or some other arrangement’

Yet, income from leasing land doesn’t qualify as passive income. Despite this, a land owner can benefit from passive income loss rules if the property nets a loss during the tax year. As far as holding land for investment - any earnings would be considered active. 

‘No Material Participation’

If an investor puts $500,000 into a candy store with the agreement that the owners would pay the investor a percentage of earnings, that would be considered passive income as long as the investor doesn’t participate in the operation of the business any meaningful way other than placing the investment. If the investor did help manage the company with the owners, the IRS argues, the investors income could be seen as active since the investor was working with the business. 

Another way to think about this is in terms of venture capital. If a general partner in a VC firm invested into the same company that the private equity fund did the earnings they received from that investment would be considered active income, while the earnings the limited partners made would be considered passive income. This is because the general partner most likely is dedicating more than just money to the company, sitting on the board or advising members of the company, while those who invested into the private equity fund that then invested their money into the company would have no ‘material’ participation.

The IRS has a test for material participation: if you’ve dedicated more than 500 hours to a business or activity in which you’re profiting from, that is material participation; if your participation in an activity was the ‘substantially all’ the participation for that tax year, that is material participation; if you’ve participated up to 100 hours and that is at least as much as any other person involved in the activity, then that is defined as material participation.

Benefits of Passive Income

When a taxpayer records a loss on a passive activity, only passive activity profits can receive have their deductions offset instead of the income as a whole. It would be considered prudent for a person to ensure all the passive activities were classified that way so they can make the most of the tax deduction. These deductions are allocated for the next tax year, and are applied in a reasonable manner that takes into account the next years earnings or losses.

Grouping Activities

To save time and effort, a person can group two or more of their passive activities into a larger activity provided they form an ‘appropriate economic unit’. When a taxpayer does this, instead of having to provide material participation in multiple activities, they only have to provide it for the activity as a whole. In addition, if a person groups multiple activities into one group and has to dispose of one of those activities, they’ve only done away with part of a larger activity as opposed to all of a smaller one. 

The organizing principle behind this grouping, ‘appropriate economic units’, is relatively simple. If the activities are located in the same geographic area, if the activities have similarities in the types of business, of if the activities are somehow interdependent, for example if they have the same customers, employees, use a single set of books for accounting.

For example, if someone who owned a pretzel store, and sneaker store located in a malls in both Monterey California, and Amarillo, Texas they would have four options of how to group their passive income. Those could be grouped into one activity since all businesses were in a mall; into two groups defined by either geography or type of business (candy and shoes, Monterey and Amarillo), or they could remain ungrouped. 

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