What is 'Passive Activity'

Passive activity is activity that a taxpayer did not materially participate in during the tax year. The Internal Revenue Service (IRS) defines two types of passive activity: trade or business activities to which the taxpayer did not actively contribute, and rental activities. Unless the taxpayer is a real estate professional, rental activities usually provide streams of income that are passive. The IRS defines material participation as involvement in the activity of the business on a regular, continuous and substantial basis.

Passive activity rules apply to individuals, estates, trusts (with the exception of grantor trusts), closely held corporations, and personal service corporations.

BREAKING DOWN 'Passive Activity'

Making a distinction between passive and active income is important for several reasons. A taxpayer can claim a passive loss against income generated from passive activities; however, a passive loss cannot be claimed against active income. This corresponds with the IRS’s passive activity loss rules. Active income refers to income generated from performing a service. This includes wages, tips, salaries, and commissions, as well as income from businesses in which the taxpayer substantially participates. For example, if a taxpayer founded a company, built and sold products, hired employees, and raised funds, these are highly active aspects of participation.

Excess passive activity loss can be carried forward to future years although it cannot be carried back.

Passive Activity and High Net Worth Individuals

Many high net worth individuals employ tax strategies that include passive activities as key means of reducing taxable income. A high net worth individual (HNWI) is defined as a single individual or a family with a net worth in terms of liquid assets over $1 million; however, the exact cutoff figure differs by financial institution and region. (Those with assets north of ~$30 million are generally considered ultra high net worth individuals.)

High net worth individuals usually qualify for additional preferential treatment with regards to investments in addition to being able to take advantage of tax strategies. (The average person does not generally have enough wealth to justify the time and cost of hiring a tax expert and/or building strategies to match active and passive income streams.) These include access to alternative investments and possible participation in initial public offerings or IPOs through their broker.

Private wealth managers jockey for the business of many HNWIs, offering highly personalized services in investment management, estate planning, tax planning, and more. The 2017 Capegemini World Wealth Report noted that the global number of high-net-worth individuals (HNWIs) grew by 7.5%. This brought the 2017 total to 16.5m, with the highest concentration in Asia.

RELATED TERMS
  1. Passive Activity Loss Rules

    Passive activity loss rules are a set of IRS rules that prohibits ...
  2. Suspended Loss

    A suspended loss is a capital loss that cannot be realized in ...
  3. Passive Investing

    Passive investing is an investment strategy to maximize returns ...
  4. Active Income

    Active income refers to income received from performing a service.
  5. Rental Real Estate Loss Allowance

    The rental real estate loss allowance is a federal tax deduction ...
  6. Active Management

    Active management consists of a human overseer or group making ...
Related Articles
  1. Investing

    Active or Passive Investing? What's Best for You

    Be strategic about which of these investing strategies you follow (and when).
  2. Investing

    How to Determine the Best Investment Strategy for You

    Before choosing passive or active investing for your portfolio, understand the differences.
  3. Investing

    Passively Versus Actively Managed Mutual Funds

    Learn about the differences between actively and passively managed mutual funds and for which types of investors each management style is best suited.
  4. Investing

    Money Managers Unite Against Passively Managed Funds

    Money managers put their heads together at summit in early November to strategize on how to overcome the loss of clients to passively managed funds.
  5. Investing

    Funds with the Largest Inflows for September, 2016 (VTI, XLRE)

    As the third quarter drew to a close, investors continued to pour money into passive funds, while active funds battled heavy outflows.
  6. Investing

    The Link Between ETF Popularity and Debt

    There may be a link between a firm's weight in bond indexes and how indebted that firm is.
  7. Retirement

    Active vs. Passive Investing for Retirees

    For most investors, sticking with a passive strategy for retirement investing will probably result in the best long-term returns. But not always.
  8. Investing

    Stock Pickers Are Shining Amid Market Turmoil

    Active investment managers performed better than passive funds in the recent stock market downturn.
  9. Investing

    Is Active Management Making a Comeback?

    The performance of actively-managed funds is starting to surpass their passive rivals. Here's why.
RELATED FAQS
  1. Passive vs Active Portfolio Management

    Understand the difference between active portfolio management and passive portfolio management, and how each strategy benefits ... Read Answer >>
  2. What are key operating activities in a company?

    Find out the things that make up a company's operating activities, including examples of some the key operating activities ... Read Answer >>
Trading Center