Is Private Lending Income treated as passive or active by IRS?

[Nicole Sun]

I have done PL lending inside of Roth IRA. Now want to branch out to my personal fund outside of Roth. A quick tax question - is the income from PL treated as passive or active in the eyes of IRS? Thanks for any insights!

[Michael Plaks]

@Nicole Sun

Welcome to BP! Couple tips on using the forum. If you want to address Nick or Lance, tag them by typing "@" and then start typing their name and click when the full name pops up. Otherwise, they cannot see that you're talking to them. And if you want to thank them for helping you, vote them up by clicking the votes counter under their photo.

The issue of different types of income can get complicated, mainly because of different classifications that are sometimes overlapping. Think of buying butter. It can be salted or unsalted. But then it can also be organic, and there're different levels of organic strictness etc. But at least when you say salted v. unsalted, even culinary morons like myself understand what it means. Not so with passive v. non-passive income and other tax-specific technical terms. 

First, there's an issue of portfolio/interest income v. business income. Unlike business income, interest income is not subject to self-employment tax, but it could be subject to net investment income tax. Most importantly, you cannot deduct business expenses against interest income. 

In order for PL to become business income it has to fit the IRS definition of a "trade or business." Unfortunately this IRS definition, like so many of theirs, is as clear as mud. Here is the proof:
https://www.irs.gov/businesses/small-businesses-self-employed/business-activities
Based on your brief description of what you do, chances are that your PL activities do qualify as a trade or business, but I cannot say that for sure unless we have a much longer discussion.

The next step is determining whether your PL business income is passive or non-passive, which matters a lot for combining income and losses from multiple activities. This depends on meeting another IRS definition, this time it is "material participation", also remarkably confusing:
https://www.irs.gov/publications/p925#en_US_2019_publink1000104581
As you can see, the 500 hrs is one way to meet this classification, but there are 6 more, and one of them is totally subjective. Are we having fun?

Considering that you have multiple real estate activities of various types and the complexity of their interplay, I would not recommend trying to learn this whole thing from an online forum. It took us tax professionals years, and we're still learning.