Passive income, as the name suggests, refers to the money that you earn without actively engaging in a business or trading activity.
Essentially, it includes rental income while investment income, such as interest, dividends, and capital gains also fall in this category. As an investor, you may not really be sure about the tax treatment of this form of earning. Some may even take it less seriously and fail to report it, which can get you in a major fix with the IRS.
Therefore, it is vital to be aware of all the rules related to passive activity income so that you may assess your investments, deductions, and taxes correctly and steer clear of complications.
Here are some significant things that every taxpayer must absolutely know about passive income and taxes.
Understand the Meaning of Passive Activity
Even before you start assessing your non-active business-related earnings, it is essential to know what all comes under the coverage of passive activity in the first place.
According to the IRS, passive activities refer to any business or trade in which the taxpayer does not participate materially. For instance, you may be a silent partner or an investor who has nothing to do with running the show directly.
It encompasses rental activity as well, including rental real estate and income from equipment leasing with only limited exceptions.
Know the Coverage of Material P articipation
The term material participation is significant when it comes to deciding whether an earning is to be regarded as passive income. Anything that involves material participation is not passive income.
There are certain criteria that are to be fulfilled in this context. For one, you must work a minimum of 500 hours a year on the project or business. Or this time span is to be more than 100 hours, while no one else works on the same project more than you. Further, if you have worked as a sole participant in the business in the project for a year or contributed almost all of the work, it is regarded as material involvement.
Similarly, if the work in multiple activities combined exceeds 500 hours, it again counts as material participation. Material participation in a minimum of five of the last ten tax years is also considered and so is that in the three previous tax years for personal services businesses.
Learn About Legitimate Tax Deductions
While you have to pay taxes on passive income, the good news is that you can claim deductions as well.
These are the ones that the IRS legally permits you to deduct from the income. Though you may do some research to learn more about these deductions, the best approach is to consult a tax attorney who can guide you in this context.
Generally, the tax benefits you can get on the rental property include the following
- The interest you pay on the mortgage every year
- Repairs to the property, which are necessary, ordinary, and reasonable in amount
- Travel expenses incurred for running and maintaining the rental property
- Depreciation losses for writing off the cost of the property over a specific period of time
- Deduction for the home office, while ensuring that it meets the minimal criteria
Learn More About the Taxation of Real Estate Passive Activities
The tax rules for real estate passive activities differ. For example, real estate rental may be considered as an active business only if strict tests to be a real estate professional is fulfilled.
This requires a minimum of 750 hours of service, in addition to more than half of the personal service being provided to come in the real estate category only. Additionally, active participation requires limited activities, such as approval of new tenants, approval of payouts, and setting rental terms.
The kind of tax treatment will depend on whether you come under the category of active or passive business.
Generally speaking, the objective of the specialized rules and tax treatment of passive activity income is to prevent the taxpayers from claiming immediate tax losses improperly on their investments. Rather, the IRS intends to limit the deductions for losses only to such businesses where they were involved actively and directly with the operation or management activities.
In a nutshell, the idea is to encourage the taxpayers to engage in profitable activities even as they wipe out the related losses that might incur. From the taxpayer’s perspective, it is essential to abide by the rules so that you always stay on the right side of the law.