A passive activity is a business activity in which a taxpayer does not materially participate.
Material participation defined. So just what is material participation? In general, material participation requires you to be involved in the operation of the activity on a regular, continuous, and substantial basis. If you do not meet this threshold, the activity is deemed passive in the eyes of the IRS.
Rental activity is generally passive. Any rental activity is generally a passive activity except for some very specific ones defined by a complicated calculation of hours spent in the activity. A limited partnership is generally considered to be a passive activity unless personal involvement meets a specified number of hours.
The passive activity rules. The complicated passive activity rules are in place to curb abuse by taxpayers who use tax-shelter losses to offset against their ordinary income (wages, interest, dividends, etc.). The rules create a separate tax basket for passive activities. The gains and losses from various passive activities are netted against each other within this basket. If the net result is a loss, the loss is generally suspended or carried forward to the next year where the process is repeated. In other words, the law generally eliminates the ability to offset ordinary income with passive losses until you dispose of an investment.
Proper tax planning dictates that you determine early on how your business activities will be viewed by the IRS. Thankfully, there are some exceptions when your income is low, but it require planning and review.