Net income provides a more accurate account of the financial status. Here’s why.
What is passive activity?
According to IRS regulations, passive activity refers to a business venture that you do not actively take part in.
For tax purposes, the IRS classifies income into two categories: active and passive. For income to fall into the active category, you must meet certain criteria to prove that you were an active participant in the business.
In contrast, a passive activity is one where you are not a material participant. This does not mean that you didn’t participate at all in the activity. It means that the venture is considered a passive activity using IRS standards. The two most common types of passive activities are running non-material businesses and holding rental units.
The distinction between active activities and passive activities is important because the IRS treats losses differently, depending on the classification. You can use losses from active activities to reduce your other forms of taxable income, such as your salary and business profits.
However, you only can use losses from passive activities to reduce income from other passive activities. If you don’t have any passive income to count the loss against in the current tax year, you can carry over the loss to future tax years until you do have passive income.
Passive activity example
If you decide to invest in a business or purchase a rental unit, this is likely a passive activity. For example, assume that you decide to purchase a restaurant with three other business partners. You do not take an active part in running the restaurant, and according to IRS regulations, this business venture qualifies as a passive activity.
If you realize losses from the restaurant, you cannot use the losses to reduce your taxable income from your salaried job. However, if you decide to sell your part in the restaurant, you can use your prior passive losses to offset the reported profit from the sale.
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