The IRS taxes “active” and “passive” incomes at different rates and under different rules. Losses from passive income cannot be used to offset gains from active income. This article will discuss different types of active and passive incomes, and the IRS rules governing these incomes.
Active incomes are wages, tips, commissions, bonuses, or business incomes that a tax payer receives from a job or business that they materially participate in. Your income is active according to the IRS if you answer yes to any of these questions:
- Did you spend at least 500 hours this year contributing towards this income?
- Did you spend at least 100 hours this year contributing towards this income, and no one contributed more time than you?
- Was your participation in this income “substantially all” of the material participation? (i.e. did no one else materially participate in this venture?)
What about hobbies? If a particular hobbyist spends over 500 hours a week on their hobby, makes money from exhibiting their hobby in competitions, and has expenses associated with their hobby, should this be considered active income? To answer these questions, the IRS has come up with various “hobby laws” to determine how a hobby is treated, or even if an activity is a hobby. The IRS looks at how the activity is treated by the tax payer to determine whether or not it is a hobby.
- Does the tax payer treat the activity in a professional manner?
- Is the activity profitable?
- Is the time that the tax payer puts into the activity indicative of their desire to make the activity profitable?
- Does the tax payer depend on the income from this activity?
- Is the tax payer capable of making this activity profitable?
In general, if the activity is profitable 3 out of the last 5 years, or 2 out of the last 7 if it involves training, breeding, or showing horses, it is considered a business.
The IRS allows deductions for hobbies, but never more than the revenues generated by the hobby. Most ordinary and necessary deductions are allowed to be taken against any hobby income, but anything that decreases basis of property must be taken last (or not at all if all hobby income has already been off-set). All hobby deductions are taken on Form 1040 Schedule A (itemized deductions) as miscellaneous deductions.
Passive incomes, meanwhile, are any income from a source that a tax payer is not materially involved in. This includes rental income (unless the tax payer is a real estate professional), dividends, interest, capital gains, and any other incomes not considered active.
As a rule of thumb, active incomes or losses and passive incomes or losses cannot off-set one another; if you have a net passive loss for the year, it cannot off-set active income.
For the average tax payer, active incomes are the most desirable. More expenses can be deducted for active incomes than passive incomes, and losses from active incomes can be used to off-set gains from other active incomes.
For example, John Doe makes $50,000 a year at a bank managing accounts for clients. He also has a few investments on the side, including $10,000 a year of rental income he receives from renting out a house he owns next door, and a small start-up he runs with his best friend from college selling fishing boats. As the job at the bank is a full-time position, it would be considered an active income. The rental income he receives would likely be considered passive income, as John is not a real estate professional. But what about the income or loss from selling fishing boats? As a start-up, it is likely that the business will not be profitable for a few years. Assuming this likelihood, will the loss be taken against his active or passive income? As we can see in this example, any passive loss in excess of $10,000 would need to be carried forward, and thus would not offset his current year tax liability. Any active loss would have to be in excess of his $50,000 salary, however, to not be realized this year.