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Isn’t “Passive Activity” an Oxymoron?
2010-02-19
In order to deduct a loss or apply credits generated by certain types of entities on your tax return, our team of tax professionals has to first determine if your participation in the activity is active or passive. Now that might sound like a small nit-picky distinction (which it is) but it’s the kind of thing that keeps us accountants in business.
And exactly how can we determine if you are active or passive? Well, it doesn’t involve a heart monitor, spy cameras, or any sort of timed trials.
First, we have to look at the type of business you are in.
There are two kinds of passive activities:
- Trade or business activities in which you do not materially participate during the year.
- Rental activities. Rental activities are almost always passive, unless you are a real estate professional.
So what does that mean, exactly?
- Well, if you have an ownership interest in a business and you earn income without participating in a meaningful way, you probably have a passive interest in that activity.
And how might we know if you are participating or not? (Do you see how preparing tax returns is kind of like navigating a corn maze at Halloween?)
According to the IRS, you materially participate in an activity if you are involved in the operation of the activity on a regular, continuous, and substantial basis. And you can’t just participate by doing investor research (the IRS is wise to that strategy too.)
The IRS has identified 7 ways to tell how material your participation is; if you can meet any one of their seven tests, your participation is material and any losses WILL not be considered passive.
The first three tests are fairly easy to understand. You materially participate if you do any of the following:
- Spend more than 500 hours on the business.
- Do the majority of the work ( you spend more time than everyone else.)
- Spend more than 100 hours working in the business and that is at least as much as someone else who works in the business.
The remaining four tests require one of those warning labels. (“Do not try this at home. Please consult a qualified professional before attempting.”) If you have losses in an activity and are concerned if they are deductible, give us a call and we’ll take care of it for you. You can read the IRS publication on this subject here : http://www.irs.gov/publications/p925/ar02.html
- If you own rental property, unless you are in the business of owning real estate (you are a developer or a property management company), you are probably involved in a passive activity. Income you generate will be taxable but any losses you generate can only be used to offset other passive income. That means you won’t be offsetting your salary and wage income with any losses coming from your rental property.
(However, you may be allowed to deduct rental losses of up to $25,000 if your income does not exceed $150,000 and you “actively participate”, not to be confused with “material participation” discussed above. Yes, this is as confusing as it sounds. “Active participation” requires you to make management decisions or arrange for others to perform services for the rental property.)
We thought you might like to know why we sometimes have to ask you strange questions about how many hours you were spending at the office, or working in a particular entity.
We’re just trying to actively pursue your passive loss deductions.
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