What Is Nonpassive Income and Losses?

What Are Nonpassive Income and Losses?

Nonpassive income and losses constitute any income or losses that cannot be classified as passive. Nonpassive income includes any active income such as wages, business income, or investment income. Nonpassive losses include losses incurred in the active management of a business. Nonpassive income and losses are usually declarable and deductible in the year incurred.

Understanding Nonpassive Income and Losses

Activities that include the taxpayer’s material participation in the effort that result in losses or income may be classified as nonpassive. According to the Internal Revenue Service, the tests for nonpassive versus passive are rooted in the time spent, and actions performed, in the pursuit of the revenue.

The losses or income may qualify as nonpassive if the taxpayer annually and actively participates for more than 500 hours in the business venture. That requirement falls to 100 hours if no other partner or co-worker puts in more work hours towards the venture than the taxpayer during the year.

This does not include, however, serving as a manager of the business if another manager is fulfilling those same duties. Furthermore, owning a business yet putting in work hours only for the sake of claiming material participation might not meet the criteria of the IRS for nonpassive.

There are other types of income that can qualify as nonpassive. Income derived from investment portfolios can receive this classification. That can include dividends, proceeds of the sale of investments, and interest. Compensation paid for the destruction or theft of property is considered nonpassive.

Sources of retirement income such as deferred compensation and social security may also be included as nonpassive. Just as income from these sources must be reported, any losses associated with these activities can be deducted from the taxpayer’s taxes.

This also includes general partnerships that have the responsibility to oversee the day-to-day operations of a business. Nonpassive losses that general partners face may, in turn, affect the business they are managing, as they may attempt to sell or its assets to address their losses. This could, in turn, lead to the closure of the business.

Examples of Nonpassive Revenue

Here are some specific examples of nonpassive revenue:

• Wages from Employment: Income earned from working as an employee in any organization, where active participation and regular effort are required.
• Business Income: Profits generated from owning and actively managing a business, such as a retail store, restaurant, or consultancy firm.
• Freelance Work: Earnings from providing services on a freelance basis, such as writing, graphic design, or software development.
• Commissions from Sales: Income earned by sales professionals or agents based on the sales they make, requiring active selling and client engagement.
• Professional Services: Revenue generated by professionals like doctors, lawyers, accountants, or consultants who provide services to clients.
• Self-Employment Income: Earnings from operating a business or trade as a sole proprietor, involving active participation in daily operations.
• Income from Partnerships: Profits from a partnership where the individual is actively involved in managing the business activities.
• Gig Economy Work: Income from short-term or flexible jobs such as driving for ride-sharing services, delivering food, or renting out properties.
• Construction Projects: Revenue earned from actively managing and working on construction or renovation projects.
• Retail Sales: Income generated from operating a retail business, including managing inventory, customer service, and sales.
• Active Stock Trading: Earnings from actively buying and selling stocks, requiring continuous monitoring and decision-making.
• Event Planning: Revenue from organizing and managing events such as weddings, conferences, and corporate functions.
• Fitness Training: Income earned by personal trainers or fitness instructors who provide training and classes to clients.
• Tutoring Services: Earnings from providing educational assistance and tutoring to students in various subjects.
• Catering Business: Profits from operating a catering service, involving menu planning, cooking, and event management.
• Real Estate Development: Income from actively developing and managing real estate projects, including property sales and rentals.
• Art and Craft Sales: Revenue from creating and selling handmade goods, involving active production and marketing efforts.
• Photography Services: Earnings from providing photography services for events, portraits, or commercial purposes.
• Consulting Services: Income from offering specialized advice and expertise to businesses or individuals in a particular field.
• Software Development: Revenue generated from developing and selling software applications, involving active coding and client interactions.

Examples of Nonpassive Losses

Here are specific examples of nonpassive losses:

• Business Operating Losses: Losses incurred when a business’s expenses exceed its revenues due to poor sales, high costs, or inefficient operations.
• Freelance Income Shortfall: Losses from freelancing when expenses for tools, marketing, and services exceed the income earned from clients.
• Retail Business Losses: Losses from operating a retail store where the cost of goods, rent, and salaries surpass sales revenue.
• Professional Practice Losses: Losses experienced by professionals such as lawyers, doctors, or consultants when practice expenses outpace client fees.
• Partnership Business Losses: Losses from a partnership where the business expenses exceed income, impacting the actively involved partners.
• Restaurant Business Losses: Losses from running a restaurant where the costs of food, staff, and overheads are higher than sales revenue.
• Real Estate Development Losses: Losses from developing properties where project costs exceed sales or rental income.
• Construction Project Losses: Losses incurred from construction projects due to delays, cost overruns, or insufficient project fees.
• Event Planning Losses: Losses from organizing events where expenses on venues, catering, and staff exceed the revenue from clients.
• Fitness Training Business Losses: Losses incurred when operating a gym or fitness center, with costs for equipment, rent, and salaries surpassing membership fees.
• Tutoring Services Losses: Losses from providing tutoring services where the cost of materials, transportation, and advertising exceed the income from students.
• Catering Business Losses: Losses from running a catering service where expenses for ingredients, staff, and logistics are higher than client payments.
• Art and Craft Business Losses: Losses incurred from creating and selling handmade goods when production and marketing costs exceed sales revenue.
• Photography Business Losses: Losses from providing photography services when expenses for equipment, travel, and marketing outpace client fees.
• Consulting Services Losses: Losses experienced when offering consulting services where the cost of operations and client acquisition exceeds consulting fees.
• Software Development Losses: Losses from developing and selling software when development costs and marketing expenses exceed sales revenue.
• Gig Economy Losses: Losses from participating in gig economy jobs where expenses such as fuel, maintenance, and platform fees surpass earnings.
• Commission-Based Sales Losses: Losses incurred by sales professionals when expenses for travel, marketing, and client acquisition exceed commission income.
• Self-Employment Losses: Losses from operating as a sole proprietor where business expenses surpass the income generated from the business activities.
• Online Business Losses: Losses from running an online business where costs for website maintenance, advertising, and shipping exceed the revenue from online sales.

The IRS and Nonpassive Activity

The IRS defines passive income specifically for tax purposes, distinguishing it from general usage. True passive income activities include trade or business activities where the taxpayer does not materially participate and rental activities unless the taxpayer is a real estate professional.

To determine whether an income is passive or nonpassive, you usually need to determine material participation. The IRS provides seven tests to define material participation, such as participating in an activity for more than 500 hours a year or having substantial involvement in the business. Meeting any of these tests means the income is nonpassive and should be reported accordingly.

To the IRS, almost all real estate activities are generally considered passive unless the taxpayer qualifies as a real estate professional by meeting specific participation requirements. Temporary rentals like Airbnb may be classified differently based on the services provided and rental duration.

For tax purposes, spouses’ participation counts toward material participation, and passive losses can only offset passive income, with excess losses carried forward to future years. Passive income is typically taxed at the individual’s marginal tax rate. We’ll also talk more about passive loss treatment later in this article.

Reporting Nonpassive Income on Tax Returns

Nonpassive income and losses are reported on your tax return depending on the source of the income. If you’re a business owner or self-employed, nonpassive income and losses are typically reported on Schedule C (Profit or Loss From Business). This form details your business income and expenses.

Wages, salaries, and other forms of employment income are reported on Form W-2, which your employer provides at the end of the year. This form shows the total amount of nonpassive income earned, as well as taxes withheld, Social Security contributions, and other relevant information. If you have multiple sources of nonpassive income, you can combine these amounts when calculating your total taxable income.

Nonpassive losses are reported similarly and can offset nonpassive income, reducing your taxable income. For instance, if your business has more expenses than it earns in revenue, you’d have a net loss. This loss can be deducted from your other nonpassive income.

Passive Activity Losses and Tax Treatment

Though this article is about nonpassive income, it’s important to highlight passive activity losses. This is the crux of why it is important (at least for tax reasons) to be able to distinguish between passive and nonpassive activity.

The IRS generally restricts the use of passive activity losses (PALs) to offset only passive income. This means that losses from passive activities cannot be used to reduce nonpassive income such as wages, salaries, or income what we listed above in this article. If passive losses exceed passive income in a given year, the excess losses cannot be deducted from nonpassive income. Instead, these excess losses are carried forward to future tax years, where they can be used to offset future passive income.

When passive activity losses are not fully deductible in the current year, they are carried forward indefinitely to future years. These carried-over losses can be used to offset passive income in subsequent years. Taxpayers have the option to group multiple passive activities into a single activity if they form an appropriate economic unit based on similarities, common control, common ownership, geographic location, and other similarities between each activity.

The Bottom Line

Nonpassive income is earned through active participation in activities like employment or running a business. Nonpassive losses are incurred from these same activities and can be used to offset nonpassive income, reducing taxable income. It’s important for tax reasons you know the difference whether something is nonpassive or passive.