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What is Passive Activity?

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  • Written By: Mary McMahon
  • Edited By: Kristen Osborne
  • Last Modified Date: 07 September 2016
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    Conjecture Corporation
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Passive activity is a profitable endeavor that someone does not actively engage in. Income from passive activity is treated differently than other types of income and there are also special rules about how passive losses can be handled. Tax authorities provide up-to-date information on how they define, tax, and handle passive activity, and accountants are usually well informed about all current and applicable standards so they can provide appropriate services to their clients.

Rental income is treated as passive activity even though landlords usually do take an active role in property management. Vacation rentals and other rentals where services considered “extraordinary” are offered are classified as active activity, however. Thus, someone who rents an apartment building and provides basic property management services would consider it passive income for tax purposes, while a person handling a vacation home would have to report the money earned as active income.

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By law, people cannot use passive losses to offset active earnings. This is designed to prevent people from creating passive losses and using them as a tax shelter, a historic problem when passive losses could be written off like regular income. People can carry a passive loss forward into another tax year, but they cannot retroactively write losses off as they can with certain types of active losses. Because the tax code periodically changes, it is advisable to consult applicable sections when preparing tax paperwork to ensure that people are filing their taxes accurately and appropriately for the given year.

Any type of profit earned when someone does not physically participate is passive income. Investment portfolios are a common example of passive activity. The client does not manage the portfolio or do any specific work to earn money. Portfolio earnings are recorded as passive earnings and losses taken on a portfolio are treated as passive losses and cannot be used to offset active earnings like salary.

Tax authorities are very familiar with the numerous financial tricks people use to reduce tax liability. They are highly alert to tactics that are not legal or that skirt the boundaries of the law and will take action if they suspect that someone is recording profits or losses inappropriately with the goal of reducing overall tax liability. Accounting services can provide assistance with differentiating between passive and active activity and filling out tax documentation properly to avoid audits and other problems that may arise.

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