There are three main categories of income: active income, passive income, and portfolio income.

"Passive income" does not include earnings from wages or active business participation, nor does it include income from dividends, interest or capital gains. For tax purposes, it is important to note that losses in passive income generally cannot offset active or portfolio income.

Under the Tax Reform Act of 1986, passive income is generated by the following:

• Any trade or business conducted for profit in which the taxpayer does not materially participate,
• And rental activity, whether or not the taxpayer materially participates,

A Schedule K-1 (Form 1065) from a partnership or a Schedule K-1 (Form 1120-S) from an S corporation may fall under the first example. If you did not materially participate during the tax year, passive losses are not allowed until you have passive income to offset them (or until the year you dispose of your entire interest in the activity in a fully taxable transaction).

For more information regarding passive income, please refer to Chapter 3 within the Passive Activity Loss Audit Technique Guide (ATG) from the IRS.

Note that any link in the information above is updated each year automatically and will take you to the most recent version of the document at the time it is accessed.