Passive Activity

[snahid11]

Hi,

I have two rental properties.  As I replace appliances, roof and etc, I do depreciation for them.  Someone asked me if I do Passive activity.  I had never heard of passive activity.  What is passive activity?  how do I apply to rental?  How is it different from depreciation?

Thanks

Sherry

[LudwigVan_fan · Accepted solution]

Depreciation is the allowance for wear and tear on assets that generally have a life of over a year.  It is a deduction allowed for taxes and in general accounting.  Often times the allowance for taxes is different than used for financial accounting.

Passive Activity is another section of the code that limits the losses from "passive activities" to the income of passive activities.  The definition of passive activity is done in law, and may be different from what you might expect it to be.  For example, you might think interest and dividends are passive....but they're not, they're considered portfolio/investment income and are NOT passive income. 

This is a complicated area of the tax law.  Rental income is defined as being passive income and any losses from rental property may be limited.  Thus if you have rental property, that is passive and you have to follow the rules of passive activities.  However, if you provided sufficient services, such as a hotel, then it would not be passive.

Below is a link to Publication 925, Passive Activity and At-Risk Rules.  I highly suggest you read the pertinent parts for your rental property, as well as if you would be considered a real estate professional, and whether you materially participate or not.

https://www.irs.gov/publications/p925

https://www.irs.gov/pub/irs-pdf/p925.pdf

Residential Rental Property

https://www.irs.gov/pub/irs-pdf/p527.pdf

Form 8582 is the Passive Activity Loss Limitation form, if it is applicable to your properties.  Most rental properties show a tax loss in the early years; so this may indeed apply to you.

https://www.irs.gov/pub/irs-pdf/f8582.pdf

https://www.irs.gov/pub/irs-pdf/i8582.pdf

Good luck.

[AmeliesUncle]

As was noted above, it isn't something that you "do".   A rental IS a passive activity, and nothing needs to be "done".  Just enter the information in the program.

[Carl]

There are two EXTREMELY BASIC types of income. Non-passive income and passive income.

Non-Passive Income - This type of income is more commonly referred to as "earned income". This is income you receive when you go out and physically "do something" to earn it. This "something you do" is usually done on a recurring basis. For example, if you have a W-2 job or are self-employed, that income you receive is non-passive, or "earned" income. This income type is subject to federal taxes, social security taxes and Medicare taxes. This type of income can be used when figuring your maximum allowable contribution to a retirement account such as an IRA, ROTH or employee sponsored 401(k).

Passive Income - This type of income is money you receive for basically doing nothing. Rental income is a type of passive income because all you do is "sit there" and collect it every rental payment period. While rental income is subject to federal taxes, it is not subject to social security or medicare tax. Passive income can not be included when figuring you maximum allowable contribution to a retirement account. Passive income can not be used for figuring your maximum allowable social security income payment when you retire and file for social security.

All real estate property classified as Residential Rental Real Estate produces passive income. So if anyone tells you their rental income is non-passive, then either they're filing fraudulent tax returns, or (and this is more likely) the property is classified as something "other" than Residential Rental Real Estate and is used for something "other" than long term residential use.

An example of such real estate would be someone who owns rental property and rents it out short term via VRBO or AirB&B. such would be a short term rental, and not long term. Most states classify a long term rental as any property that is rented for more than 30 days for any one period during the tax year. THink of a short term rental operation exactly the same as a hotel operation.

In my state, a short term rental is defined as any real estate property that is rented out for "less" than 30 days for "any" "one" "period" during the tax year. They define it this way so they can assess tangible property taxes on short term rental owners.