Passivity in business will cost you at tax time. When the IRS classes your business activity as "passive," it limits your ability to write off red ink. Such activities businesses that generate income for you, such renting residential property. The IRS counts them as passive unless you "materially participate" in the income-generating activity.
The IRS has multiple tests for material participation. Passing any one of them proves your activity is non-passive. You can qualify by participating for more than 500 hours in the year, or for 100 hours if none of your partners or co-workers put in more time. Managing the business doesn't count if the business employs another manager. If you own a business and materially participate only to improve your tax position, the IRS may decide your activity is still passive.
Rental and Other Income
Unless you're a real-estate professional, renting out property is always classed as a passive activity. Income from your investment portfolio, on the other hand -- interest, dividends, gains from selling investments -- is not passive. Social Security benefits, deferred compensation and other retirement income isn't passive either. Neither is reimbursement for the theft or destruction of your property. It's important to classify your income correctly, because of the way the IRS treats losses from passive activities.
If you lose money on a business you materially participate in, you can write off the losses against your other income. If it's a passive activity -- you own a business, for example, but someone else makes all management decisions -- you can only deduct the losses from other passive losses. If you have a total $4,000 in passive income and $6,000 in losses, you can only deduct $4,000 this year. You can, however, carry over the remaining $2,000 and deduct it from passive income in later years.
One way to write off more losses is to group your businesses. If you own two separate businesses in one mall, for instance, and materially participate in one of them, grouping them together as one activity makes all the income non-passive. Although renting property is considered passive, the IRS makes an exception with regard to deductions for taxpayers who own a rental and actively participate in managing it -- for example, by negotiating leases, advertising vacancies, vetting tenants, and contracting for repairs. If you actively participate in this way, the IRS allows you to deduct up to $25,000 in losses from non-passive income.