Nonpassive income and losses are derived from business activities that result in gains and losses for the taxpayer. Nonpassive income arises from active income activities, such as business income, investment income, or employment earnings or retirement income. On the other hand, nonpassive losses include losses incurred in the active management of a business.
Nonpassive incomes and losses are not only subject to full disclosure, but also are deductible in the tax year when they occur. The classification of a loss as either passive or nonpassive determines if the loss can be deductible for tax purposes.
Understanding Nonpassive Income and Losses
Nonpassive activities resulting in income and losses cannot be offset by deductions generated from business activities that generate passive income or losses unless a taxpayer materially participated in the business operation in the past. The rule is premised on passive activity rule, which aims to curb tax sheltering.
For example, losses from partnerships cannot offset income from employment. However, income from passive activities can be offset by losses from passive activities that create investments aiming to attain a tax loss without a corresponding economic loss.
The origin of the rule can be traced back to the 1980s. During the period, investors used to offset earned and unearned income by creating losses to avoid the taxman. Investors generated losses by manipulating transactions to generate accelerated deductions, such as interest and depreciation. However, offsetting is exempt in non-loan situations, which are applicable in self-charged transactions.
Nonpassive income and losses are any earnings or losses that cannot be classified as passive.
A business activity or trade is considered nonpassive if a taxpayer materially participated in a business venture.
The criteria for nonpassive business activities include performed action, the pursuit of the revenue, and overall duration.
A business activity or trade is classified as nonpassive if a taxpayer materially participated in the activity that resulted in an income or loss. Seven tests exist that the Internal Revenue Service (IRS) uses to determine if a taxpayer materially participated in a venture. The tests include:
One participated in the activity for a period exceeding 500 hours during the tax year.
One solely participated in the activity for the entire tax year.
One participated in the activity more than anyone else involved in the activity – typically for more than 100 hours.
One participated in all the significant activities, each for more than 100 hours, thereby meeting the 500-hour test.
One spent more than three years offering personal services to the activity.
One consistently participated in the activity based on all the factors and circumstances.
Common Sources of Nonpassive Income and Losses
Common sources of nonpassive income and losses include:
Business activity or trades that a person engages in during the tax year.
Working interest in energy resources such as oil and gas. The working interest must be held directly or via an entity that does not limit liabilities. In such a case, regardless of whether someone materially participated in the activities for the tax year, it is still a nonpassive activity.
However, if the liabilities were limited for a defined period, part of the losses and incomes from the working interest is classified as passive activity and income.
The rental of a residential unit that the owner resides in. It only applies if one previously concurrently rented out the residence and used it as a home in the same tax year for several days, i.e., exceeding 14 days.
The activity of trading private property for the benefit of interest owners in the activity.
Activities involving low-income housing. In such a case, an investor who is qualified to be in low-income housing activities is guaranteed transitional relief. In some cases, income and losses drawn from low-income housing are treated as a nonpassive activity for seven years.
The tests for both nonpassive and passive business activities are hinged on the performed action, the pursuit of the revenue, and the time taken. The above tests generate income or losses, which are considered nonpassive except when an individual is serving as the business’ manager while, at the same time, another manager is performing similar functions. Also, the nonpassive criteria of the IRS might not be met when one is performing managerial roles only for the sake of achieving material participation.
Certain types of income can be classified under the nonpassive type. For example, portfolio income meets the requirement. Portfolio incomes can include royalties received from an investment property, interests, dividends, and capital gains. Compensation resulting from vandalism or theft is also considered nonpassive.
Additional sources of income that qualify for the classification include social security and deferred payments. The IRS requires income from such sources to be reported, and any losses emanating from such activities be relieved from taxes for the tax year. In addition, general partnerships mandated to oversee the daily running of a business are deducted from the taxpayer’s tax.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:
Learn accounting fundamentals and how to read financial statements with CFI’s free online accounting classes.
These courses will give the confidence you need to perform world-class financial analyst work. Start now!
Building confidence in your accounting skills is easy with CFI courses! Enroll now for FREE to start advancing your career!