Tax law distinguishes between active income and passive income. Returns generated from investments or business activities that require the continued effort of the taxpayer are considered active income. Consider returns coming from investments or business activities that require little or no participation from the taxpayer passive income. Another type of income is portfolio income, which includes returns from investments. Some examples include both dividends and capital gains.
The key distinction is that passive losses cannot be deducted from active or portfolio income. Furthermore, passive losses can only be deducted from income that is passive. If passive losses are incurred when the taxpayer has no offsetting passive income, then these losses can be carried forward to a year when the taxpayer does have offsetting the income that is passive.
Examples include the following:
- Income from rental property
- Limited partnerships
- Book or patent royalties
- Other sources of income that do not require the material participation of the taxpayer.