Passive Income Generators (PIG)

By Jason Watson, CPA
Posted Saturday, August 10 2024

In 1986, the Reagan administration and Congress blasted away at passive losses or what others might have called abusive tax shelters. With the updated passive activity loss rules, only passive income could offset passive losses with the $25,000 real estate rental exception.

In the context of real estate and rental properties, you only have three basic options to deduct your activity’s losses-

• Fit into the narrow window for the $25,000 passive loss allowance for rental properties.
• Qualify as a real estate professional or what some call REPS.
• Have your rental activity qualify as a short-term rental with average guest stays 7 days or fewer with your material participation (which we discuss in a later section). This is also referred to as the short-term rental (STR) loophole.

A fourth option is to find some passive activity that throws off passive income. Ergo, the passive income generator or fondly referred to as a PIG. There are plenty of private equity funds or other real estate investments that can offer passive income. The income is passive since you are not materially participating in the investment.

Sidebar: Needless to say these investments must be heavily scrutinized. How much income can they really provide? What is your cost of equity versus the income generated including the value of using otherwise unallowed passive losses? What is the redemption policy (the exit plan and limitations)?

You can also invest in a business. This gets tricky of course since you cannot materially participate in the day-to-day operations, yet your money is invested (trapped?) into the entity. This can be unnerving. Keep in mind too that dividends and capital gains generated by a business, or what is called portfolio income, are not considered passive income even if your involvement in the investment is passive. In reviewing a K-1 from a partnership tax return, you will separate boxes for ordinary income, dividends, interest income and capital gains.

Are you a business owner? Could you deem your business income (profits) to be passive by not materially participating in the activity? Unlikely, at least for a while. We explore the rules on being considered a passive business owner in a later section.

Keep in mind the classic phrase- pigs get fed and hogs get slaughtered.