J.K. Lasser's Your Income Tax 2013: For Preparing Your 2012 Tax Return

10.9 Passive Income Recharacterized as Nonpassive Income

There is an advantage in treating income as passive income when you have passive losses that may offset the income. However, the law may prevent you from treating certain income as passive income. The conversion of passive income to nonpassive income is technically called “recharacterization.” This may occur when you do not materially participate in the business activity, but are sufficiently active for the IRS to consider your participation as significant. Recharacterization may also occur when you rent property to a business in which you materially participate, rent nondepreciable property, or sell development rental property.

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Caution

“Recharacterization” of Passive Income

Gain on the sale of property used in a passive activity may be recharacterized as nonpassive income if the property was formerly used in a nonpassive activity (10.16).

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Significant participation.

The IRS compares income and losses from all of your activities in which you work more than 100 hours but less than 500 and that are not considered material participation under the law. If you show a net aggregate gain, part of your gain is treated as nonpassive income according to the computation illustrated in the following Example.

EXAMPLE

Carol Warren invests in three business activities—A, B, and C. She does ...