What Are Some Passive Activity Examples?

The Internal Revenue Service (IRS) classifies income-generating endeavors into distinct categories for tax reporting purposes. This system of classification influences how income and losses are treated on a tax return. The character of an activity determines the specific rules that apply, particularly concerning the deductibility of any losses incurred. The level and nature of a person’s participation can shift an activity from one category to another, altering its tax implications, so taxpayers must assess their activities each year to ensure they are reported correctly.

Defining Passive Activities

The IRS formally defines a passive activity as falling into one of two primary categories. The first includes any trade or business in which a taxpayer does not materially participate during the tax year. The second category covers most rental activities, which are considered passive by default, even if the owner does materially participate, though some exceptions exist.

The distinction between passive and non-passive activities is important because of the Passive Activity Loss (PAL) rules, established under Section 469 of the tax code. These rules stipulate that losses generated from passive activities can generally only be used to offset income from other passive activities. If a taxpayer’s total passive losses exceed their total passive income for the year, the excess loss is disallowed for that year and cannot be used to reduce non-passive income, such as wages or portfolio income.

This limitation is tracked on Form 8582, Passive Activity Loss Limitations. Any disallowed passive loss is not permanently lost; instead, it is suspended and carried forward to future tax years. In subsequent years, these suspended losses can be used to offset future passive income. If the taxpayer disposes of their entire interest in the passive activity in a fully taxable transaction to an unrelated party, any suspended losses from that specific activity are typically released and can be deducted against other forms of income.

The Material Participation Tests

The IRS outlines seven distinct tests in Publication 925 to determine if a taxpayer has materially participated in a trade or business activity. Meeting just one of these tests for a given tax year is sufficient to classify the activity as non-passive, or “active.” These tests are based on the number of hours contributed and the nature of the involvement.

The first test is met if an individual participates in the activity for more than 500 hours during the tax year. Another test considers whether an individual’s involvement was substantially all the participation in the activity for the tax year. This means if the taxpayer was essentially the only person working in the business, they meet the standard, regardless of the total hours worked.

A person also materially participates if they spend more than 100 hours on the activity, and that amount of time is at least as much as any other individual involved. The significant participation activity (SPA) test is more complex. An SPA is a trade or business in which an individual participates for more than 100 hours but does not otherwise meet any of the other material participation tests. If a taxpayer’s combined participation in all of their SPAs for the year exceeds 500 hours, they are considered to have materially participated in each of those activities.

Two tests look back at prior years of involvement. A taxpayer materially participates if they materially participated in the activity for any five of the preceding ten tax years. For personal service activities, such as those in fields like health or law, the rule is different: the taxpayer meets the test if they materially participated in any three prior tax years.

The final criterion is a facts-and-circumstances test, which allows for a determination based on regular, continuous, and substantial participation during the year. However, this test cannot be met if the individual participated for 100 hours or less, and time spent in a management capacity does not count if someone else was compensated for managing the activity or spent more hours managing it than the taxpayer.

Common Passive Activity Scenarios

The most common example for many people is owning rental real estate. Whether it’s a single-family home, a condo, or a commercial building that is leased to tenants, these activities are generally defined as passive by the tax code, regardless of the owner’s level of involvement. This default classification means any net losses from the rental are subject to the PAL limitations.

Another frequent scenario involves participation in a limited partnership. By design, a limited partner’s role is restricted to their capital investment, with no active involvement in management or operations. This legal structure inherently makes their participation passive. Consequently, any income or loss passed through to the limited partner from the partnership is treated as passive.

A third common example is investing capital in a friend’s or family member’s business without being involved in its operations. An individual might provide startup funds for a local restaurant or a small tech company but have no role in the day-to-day management, decision-making, or work. In this case, the investor would fail all seven of the material participation tests, making their involvement passive.

Activities That Are Not Passive

The most direct contrast is an active trade or business. If a taxpayer meets any of the seven material participation tests for a trade or business activity, that activity is considered active, and any resulting income or loss is non-passive. This includes being the sole proprietor of a shop you run daily or being a partner in a firm where you work more than 500 hours a year.

Another major category of non-passive income is portfolio income. This includes income generated from investments rather than from a trade, business, or rental activity. Common examples of portfolio income are interest from bank accounts or bonds, dividends from stocks, and royalties not derived in the ordinary course of a business. Gains from selling investment property, like stocks or undeveloped land, also fall into this category.

The tax code also carves out specific statutory exceptions, defining certain activities as non-passive even if they might appear to be. A primary example is the exception for certain real estate professionals. If a taxpayer meets specific requirements related to their time spent in real property trades or businesses, they can treat their rental real estate activities as non-passive. A working interest in an oil and gas property is another notable exception if the owner’s liability is not limited.