Posted by Fred Lake

Passive Activity & Other Types of Income

Passive Activity & Other Types of Income

Classifying assets between liabilities and non-liabilities is not an easy task. This can often determine whether a current income deduction is received or what tax rate should be applied. In general, passive losses can only offset income from other passive assets. If you have a lot of passive income, you will be subject to the 3.8% Medicare surtax. When taxpayers have no other passive income, a reduced activity must be non-passive to qualify for a current deduction. One of the seven tests must be completed to be considered a non-passive activity.

To get started, here is an IRS list of passive and non-passive assets:

Passive Activities

Income and losses from the following assets are generally passive:

  • Equipment rental

  • Individual or agricultural property in which the taxpayer does not materially participate

  • Limited partnership, with some exceptions

  • Property rental (with a few exceptions)

  • S-Corporations, limited liability companies, partnerships in which the taxpayer does not physically participate

Non-passive Activities

Income and losses from the following are non-passive:

  • General trusts in which the fiduciary material participates

  • Guaranteed payments

  • Interest and dividends

  • Royalties arising from the normal course of business

  • Salaries, wages, and 1099 commission income

  • Sale of undeveloped land or other real estate investments

  • S-Corporations, partnerships, and limited liability in which the taxpayer makes a significant contribution

  • Farm or sole proprietorship in which the taxpayer materially participates

  • Stocks and bonds

More net investment taxes, S Corps and self-rentals

The net investment tax has been discussed before. In general, passive income, such as rental income, will be treated as net investment income and subject to the Medicare tax. It is common for the owner of a business that relies on machinery or equipment to have two business entities. An entity is an LLC that owns the assets. The other entity is an S corporation that leases LLC assets for business purposes. This directly reduces S Corp's income and eventually lowers the company's wages to pay shareholders. 

The LLC activities are considered independent leasing activities, which means that you are creating a transaction with yourself. As long as this deal is at market price, the IRS will accept this report. Also, rental income from self-employment is not considered as passive activity and is therefore not subject to the calculation of net investment income tax.

Here is the code. Regulation Section 1.469-2:

(f)(6) Property leased for a non-passive activity. An amount of the taxpayer's gross income from the rental activity for a taxable year, the amount of the property is equal to the amount of the net income from the rental activity for the year of that property is considered a non-passive activity if the property is:

  • Rented for use in a business or commercial activity (within the interpretation of paragraph (e)(2) of this section) in which the taxpayer participates materially (within the purview of section 1.469-5T) for a taxable year.

  • Not outlined in section 1.469-2T (f)(5).

Let's sum it up. If you have a self-rental business in which you are materially involved, this income is not considered passive income.

Car rental situations are not limited to buildings. You can rent a car to your S Corporation. No, it's not the same as renting a car from a dealership. Here, you own the equipment, like a car, and you lease it for commercial use to your business. It looks exotic, but it's very simple. 

Interest income generated from loans to S-Corps is also excluded from the Net Investment Income tax calculation to the extent of your non-passive deduction.

For Example John and Jane own a business as 60-40 partners. John received $1,000 in interest income from the business because he loaned the money to the business. John owns 60% of the company. Therefore, John can exclude $600 from his net investment income because it is his allocated portion of non-passive income activity. The remaining $400 would be subject to the net return on investment tax calculation. 

Summary of income types

We talk a lot about the type of income and how it is treated. Here is a summary.

  • Earned income is subject to self-employment taxes for the self-employed or to payroll taxes in the form of social security and health insurance taxes for the W-2 employee. 

  • Non-passive income cannot be offset or reduced by passive losses, except for the $25,000 figure. Therefore, if you have passive losses of $100,000 on your rental properties and car rental income of $100,000 for your business, your non-passive income can be reduced to just $75,000.

  • Passive losses can be deducted from other income forms, such as earned income, portfolio income, and non-passive income up to a limit of $25,000. This requires that your participation be considered active, which is a much simpler limitation than physical participation—usually 100 hours.

  • Passive losses can and must only be deducted from passive income in general. But there are exceptions, of course.

  • Rental income is considered passive income taxed only at the normal rate of income tax (instead of being taxed twice, once with own account taxes and again with normal income taxes). Rental losses are considered passive losses.

  • The passive loss deduction for active loss is limited when the adjusted gross income exceeds $100,000 and is reduced to zero by $150,000. These unauthorized losses are reported for use when income or asset disposals permit.

  • The portfolio income comes from the sale of assets and is taxed either at the capital gains rate or at the normal rate of income tax, depending on the asset's life. Interest and dividends are also considered portfolio income. It's that simple.



Fred Lake
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