What it means
Tax rules in several countries, notably the United States, split income into categories. Passive income includes things like rent from a property managed by someone else, or profit from a business in which the owner does not materially take part.
Non-passive income covers wages, profit from a business in which the owner is actively involved, and in some systems certain other items. The split exists to stop people from using paper losses from investments they barely touch to wipe out taxes on their salary.
If a loss is passive, it can usually only be used against passive income and any excess is carried forward. A non-passive loss is generally more flexible and can often be used against other non-passive income in the same year.
The key test is involvement. In the United States, the idea of material participation looks at factors such as the hours worked and whether the person is involved on a regular, continuous and substantial basis.
Other countries use their own tests, so the label depends on local law and the facts. For founders and managers, this matters when deciding how to hold investments and how to structure a business.
An owner who works full-time in a company usually has non-passive results from it, while a silent investor in the same company often has passive ones. Classification can also change from year to year.
A landlord who spends many hours managing properties might qualify differently from one who uses a managing agent, and keeping a record of time spent is good evidence for the tax return. The rules are detailed and the thresholds are set and updated by the tax authorities.
Always confirm the current position with a qualified adviser before relying on a particular treatment.
In practice
Real-world examples.
Example
A consultant owns a design studio and works in it full time. The studio loses $15,000 in its first year, and because the work is non-passive, the loss can generally be set against her other active earnings. That could reduce her taxable income from $110,000 to $95,000 for the year.
Example
A retired investor owns shares in a limited partnership that runs hotels, but takes no part in management. His share of the losses is passive and can only offset other passive income. Any unused loss is carried forward to a later year.
Example
A doctor owns a small clinic, working 40 hours a week there, and also receives rent from a flat run by an agent. The clinic profit is non-passive while the rent is passive, and the two are reported separately. A loss on the flat could not reduce the clinic profit in the same way.
Formula
Calculation
Taxable active income = Non-passive income - Non-passive losses
An owner-manager earns a $90,000 salary and $60,000 of profit from a business in which she works full time, so her non-passive income is $90,000 + $60,000 = $150,000. She also has a $20,000 loss from a bakery she runs and works in daily, which is non-passive. Taxable active income = $150,000 - $20,000 = $130,000. If the bakery were instead a passive investment, the $20,000 loss could generally not reduce her $150,000 and would be carried forward. Her taxable active income would then stay at $150,000 until the bakery produced passive income to absorb the loss.Case study
Seen in the real world.
Redfern Advisory is a fictional accounting practice invented for this illustration. A client, Tomas, invested $100,000 in a restaurant and expected to use its $30,000 first-year loss against his $180,000 salary.
His adviser pointed out that Tomas had not worked in the restaurant and had no management role, so the loss was likely to be passive. It could not reduce his salary income and would be carried forward until the restaurant earned profit or he sold his interest.
Tomas then asked what would change if he took on a day-to-day role. The adviser explained that increased involvement might change the classification in future years, but only if he genuinely met the participation tests, and that he should keep a log of his hours.
Watch out
Common mistakes.
- Assuming every business loss reduces salary income. If the activity is passive, the loss may be locked until there is passive income to offset.
- Claiming involvement without evidence. Tax authorities may ask for logs of hours and duties.
- Forgetting that classification can change. A change in role or hours can move an activity from one category to the other.
Questions
People also ask.
Is salary always non-passive?
Generally yes, because it is earned from active work. Portfolio income such as interest and dividends is usually treated as a separate category and is neither wages nor business profit.
Can unused passive losses be used later?
In many systems they are carried forward and can be used against future passive income or when the investment is sold.
Who decides whether income is passive?
The tax law of the country sets the tests, and the taxpayer applies them when filing, subject to review by the tax authority.
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