Passive activity income is generally income produced from a trade or business which you materially participate in during the tax year. The idea behind passive activity restrictions is that a taxpayer who participates in an activity is more likely to engage in the activity with a significant non-tax profit motive, and form a sound judgment as to whether the activity has genuine economic significance and value.

What Types of Passive Activity Income Are There out There?

The IRS notes two kinds of passive activities: trade or business activities in which one does not materially participate during the tax year, and rental activities, whether or not the taxpayer materially participates.

To Whom Do Passive Activity Restrictions Apply?

Passive activity restrictions apply to:

Can I Take a Passive Activity Loss/Deduction on My Tax Return?

You may generally include all income or losses other than those related to an active trade or business, or portfolio income (e.g., interest, dividends, royalties, annuities, and gain or loss from the sale of portfolio assets) on your tax return. In general, passive activity losses can only offset passive activity income, and passive activity tax credits can only be used against tax attributable to passive activity income on your tax return.

What Is a Hobby Loss?

This is a loss from a hobby or other activity you do not pursue for profit. You cannot claim expenses from a hobby that exceed the amount of the overall income that you report for a tax year.

When Do I Get a Deduction for a Hobby Loss?

A taxpayer gets a deduction for a second business or hobby activity when they can prove they conduct that second activity or hobby for a profit motive.

How Do I Prove that I Have a Profit Motive for My Hobby or Second Business?

If you make a profit on your second business or hobby activity in three of the last five years, you are presumed to have a profit motive. The IRS also looks at a number of other factors to determine if you are in a second business or hobby with a profit motive. These factors include the following:

  • Do you maintain a separate bank account for business?
  • Do you have a name for your business?
  • Do you keep a set of books?
  • Do you have a business license?
  • Do you have a separate area in your house where you conduct your business?
  • Do you have a separate phone and fax line for business?
  • Do you have stationery and business cards?
  • Do you have a business plan?
  • Do you advertise, market, or promote your business?
  • Do you spend time each day or week on your business?
  • Are you trying new ways to advertise and market your business?
  • Are you meeting with customers and clients each week?
  • Are you making a reasonable effort to make a profit the way other people do in this business?
  • Are your losses due to circumstances beyond your control?
  • Do you have a track record of past profitable ventures?
  • Have you had a profit in any previous years?
  • Are your losses getting smaller each year?
  • Do you have a reasonable level of expertise in this area?
  • Do you depend on income from the activity to live on?

Should I Contact a Lawyer?

With the variety of tax software available, most people are capable of doing their taxes on their own. More sophisticated and more complex tax returns (i.e., those done by business owners) may require more time and perhaps the advice of a lawyer. Additionally, should you have a dispute with the taxing authority regarding your loss deduction, you may need to go to court, where you will certainly need the assistance of an experienced tax lawyer.