Why does the income from our charter yacht show up as passive when we actively and materially manage the business?

[wrnoof]

My wife and I have an LLC/Partnership that owns a sailboat. The boat rentals are scheduled by a charter management company. We actively and materially participate in this rental property through promotion, equipment purchases, on-site and sea trial inspections, etc. Our expenses outside the management company activity are listed as ordinary business loss on the partnership K-1 and the charter income from the management company is reported as "Other Rental Income" on K-1, line 3 and Form 1065, Schedule K, line 3a. When the K-1 information is transferred to our personal income return, the charter income on K-1, line 3 shows up as passive on Schedule E, line 28 even though our participation qualifies as active and material. This first year of business, our expenses exceed the charter income and there is a net loss. Do we need to show the income from the management company as non-passive and, if so, how do we do that?

[ThomasM125]

You would have to list the income in box 1 on your K-1 schedule as ordinary income in order for it to be considered as being non-passive. One way you could do that is if the average rental period during the year was less than seven days. If you were running a bed and breakfast type of activity and you provided daily services like cleaning and food preparation, that may also be a way to have the activity considered non-passive. Also, your material participation must consist of more that 500 hours in a year, or more then 100 hours and no-one else participates more than that. So, it may be difficult for you to treat the acticity as non-passive.

[wrnoof]

Thanks for the quick response. It's helpful. I'm confident we qualify as non-rental and material participation under the passive activity rules.

[wrnoof]

One more item. The less-than-7-day-average-rental-period and some other tests do not determine whether the activity is passive or non-passive. Rental activity is passive by definition. Passing the 7-day test simply means the activity is not considered a rental activity, but not being a rental activity does not necessarily mean it is not passive. It could still be passive if one fails the second tier of tests such as the 100 hour or 500 hour tests. Including the yacht income on line 1 or box 1 only means I believe the activity is not rental and, therefore, not passive by definition. Once the K-1 is issued, I must have material participation in the non-rental activity to avoid being passive. That is done when the K-1 is incorporated into the 1040 individual tax return.