Some taxpayers might really like to stretch the definition of passive income. You see, you can only write off passive losses against passive income; therefore, the more passive income you can claim, the more losses you can write off immediately. Unfortunately, the IRS definition of passive income does not include capital gains.
If, say, you own land that doubles in value overnight, you may feel you made money passively. The IRS, however, defines passive activity very precisely. Rental income is almost always passive, unless you're a real-estate professional. Businesses you invest or work in but don't materially participate in generate passive income. But when you generate capital gains from the sale of, say, stocks or land, you earn active income as far as the IRS is concerned.
You materially participate in a business when you work at it on a "regular, continuous and substantial basis." The IRS has a list of seven tests for figuring that out. The tests include working 500 hours or more in the business during the year; working fewer hours but doing all the work; or working more than everyone else employed there. You can only claim business income as passive income if you flunk all seven of the tests.
Your capital gains and your passive income follow separate paths through the tax world. You report your capital gains on Schedule D and pay the appropriate tax rate, which may be equal to or less than your regular income tax rate. With a loss, you can deduct up to $3,000 from other income, and then you roll over the rest to subsequent years. You report passive income on Schedule C, D, E or F, depending on the nature of your investment. Any passive losses greater than passive income get rolled over to next year.
If you have more than one business activity going, their active or passive status may change when you group them together. Suppose, for example, you have two businesses running in the same mall. Group them as one business -- you can do this even if they're separate companies -- and you may have enough hours combined that you can claim active participation. In that case, you may be able to deduct any losses from your non-passive income.
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