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.

Understanding 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.

Key Takeaways

  • The IRS sets and defines the rules for passive activity loss.
  • Passive activity loss rules can be applied to businesses and individuals, except C corporations.
  • Leasing equipment, home rentals, and limited partnership are all considered examples of common passive activity.
  • When investors are not materially involved they can claim passive losses from investments like rental properties. 

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.

Individuals who rent out second homes or own more than one residence are advised by experts to seek out professional accountants to verify whether a loss can be classified as passive.

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

Special Considerations

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.

HNWIs appear to be on the decline. Capgemini’s World Wealth Report 2019 reported "with a loss of 2 trillion USD, High Net Worth Individual wealth declines after seven consecutive years of growth."