CLIENT KNOWLEDGE BASE

    Carving Out a Passive Activity

    Often times, business owners begin investing in real estate but they are unable to take advantage of the losses created through accelerated depreciation.  The business activity is "nonpassive" while their real estate investing is passive.  While there is nothing wrong with this scenario, the losses accrue and erode due to time value money. 

    One advanced strategy we have used involves carving out a portion of your operating business as a passive activity to generate passive income, which can be offset by passive losses.


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      Understanding Passive Activities

      A passive activity is any trade or business in which the taxpayer does not materially participate. 

      Material Participation (what we need to FAIL in this case)

      Material participation is determined by several tests outlined in IRS regulations, which include:

      1. The Individual Participation Test: The taxpayer works more than 500 hours in the activity during the year.
      2. The Substantially All Participation Test: The taxpayer's participation is substantially all the participation in the activity of all individuals for the year.
      3. The More Than 100 Hours and More Than Anyone Else Test: The taxpayer works more than 100 hours in the activity and no one else works more hours.
      4. The Significant Participation Activities Test: The taxpayer participates in several significant participation activities that aggregate to more than 500 hours.
      5. The Material Participation in Any 5 of the Last 10 Years Test: The taxpayer materially participated in the activity for any 5 of the last 10 years.
      6. The Personal Service Activity Test: The activity is a personal service activity, and the taxpayer materially participated for any 3 preceding years.
      7. The Facts and Circumstances Test: Based on the facts and circumstances, the taxpayer works regularly, continuously, and substantially in the activity.
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      Carving Out a Passive Activity in your Operating Business

      Identifying the Activity to Carve Out

      Select a portion of your operating business that can be structured as a separate service or activity. This could be a new service line, a distinct offering, or a separate department that can operate independently without YOU as the business owner materially participating. 

      Creating a Separate Entity

      To clearly delineate the passive activity, we would first help you set up a separate legal entity for the carved-out portion. This could be an LLC, partnership, or S corporation, depending on the business structure that best suits your needs.

      Ensuring Lack of Material Participation

      To qualify as a passive activity, the owner must not materially participate in the new entity. This means we have to ensure you your involvement to purposely fail the passive activity rules. 
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      Example: Carving Out a Passive Activity

      Step 1: Establish the New Entity

      Jane creates RealMarketing LLC, a separate entity from SEOManage LLC. This new entity will provide property management services to residential properties.

      Step 2: Define Roles and Responsibilities

      Jane hires a manager to oversee the day-to-day operations of RealMarketing LLC. This manager handles tenant relations, maintenance requests, and financial management of the properties.

      Step 3: Ensure Lack of Material Participation

      To comply with IRC 469 and classify RealMarketing LLC as a passive activity, Jane limits her involvement to high-level strategic decisions and quarterly reviews of financial reports. 

      She ensures she does not meet any of the material participation tests:
      • The Individual Participation Test: Jane spends less than 100 hours per year on RealMarketingLLC activities.
      • The Substantially All Participation Test: The hired manager performs the majority of the work, far exceeding Jane's involvement.
      • The More Than 100 Hours and More Than Anyone Else Test: Jane's hours are significantly fewer than those of the manager.
      • The Significant Participation Activities Test: Jane's involvement in other significant participation activities within SEOManage LLC and other ventures totals more than 500 hours, but RealMarketing LLC's activities do not aggregate to this amount.
      • The Material Participation in Any 5 of the Last 10 Years Test: RealMarketing LLC is a new entity, and Jane has not materially participated in it previously.
      • The Personal Service Activity Test: RealMarketing LLC is not a personal service activity.
      • The Facts and Circumstances Test: Jane’s participation is limited and does not qualify as regular, continuous, and substantial.

      Step 4: Document Participation to Ensure you are Audit Proof

      Jane keeps detailed records of her time spent on RealMarketing LLC to substantiate her lack of material participation. She logs hours spent on strategic decisions, reviewing financial reports, and any meetings.
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      Benefits of Carving Out a Passive Activity

      Offset Passive Income with Passive Losses

      By creating passive income through RealMarketing LLC, Jane can use passive losses from other investments, including passive real estate, to offset this income, reducing the overall tax liability.

      Interested?  Drop your PM a note on Soraban!
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