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Gross Income

Portfolio Income * Active Income * Passive Income * Back to Filing Status * Back to the Index

Depending upon the source, income is classified into one of three categories: portfolio (investment) income, active income and the often dreaded passive income. Certain deductions are limited due to the different types of income.

Portfolio or Investment Income consists primarily of interest and dividends and gains generated from the sale of stock. Portfolio income is income generated by an activity that is not considered a trade or business. The deductibility of investment expense is limited by the amount of investment income. Click here to find out more about how Portfolio Income can save you money on your taxes.

Active Income is income from salary, farm income, sole proprietorship business, S corporation and partnership income in which the taxpayer materially participates in the business operation. Click here to find out more about how Active Income can save you money on your taxes.

Passive Income is income generated by a business operation in which the taxpayer does not materially participate. Losses from a passive business can be used only to offset passive income. Unused passive losses can be carried forward indefinably and deducted against passive income in future years or upon the disposition of the passive activity. Click here to find out how Passive Income can save you money on your taxes.

Material Participation: The distinction between active income and passive income depends on the extent of the taxpayer's participation in the business operation. Taxpayer's participation on a regular and continuous basis is considered material and any income or loss is active income. If the taxpayer's participation does not meet the IRS standards for material participation, then any income or loss generated will be considered passive unless the rules for significant participation are met. Generally, income from real estate rentals is considered passive. Short term rentals (7 days or less, or 30 days or less with services provided) can be active income if the taxpayer materially participates.

Material participation is defined in terms of number of hours devoted to the activity. If you work more than 500 hours per year, or if you worked more than 100 hours during the year and no else works more than 100 hours, you meet the material participation test. Other tests for meeting material participation include:

  1. The taxpayer's work constitutes substantially all of the work in the activity.
  2. The taxpayer satisfied a material participation standard in at least 5 out of the last 10 years.
  3. The taxpayer in a personal service activity satisfied a material participation standard in at least three years.

Pointer: The spouse's participation in an activity is added to the taxpayer's to determine the degree of participation in an activity.

Gains and losses generated from the disposition of income producing assets are generally classified in an identical manner as the income produced with the exception of a passive investment. The passive losses that have been carried forward will be used to offset income in the following order:

  1. Current year passive activity income from that activity, including the gain from the sale.
  2. Net income or gain from all other passive activities.
  3. Any other nonpassive income or gain.

Caution: Passive activity losses that have been carried forward can not be used if the passive investment is sold to a related party. The passive losses must be carried forward until the passive investment is later sold by the related party. Also, if the passive investment is sold reporting as an installment sale, then the loss can only be used as the buyer makes payments.

Pointer: As the year-end approaches watch the number of hours you have devoted to an activity if losses are expected. Increase the number of hours worked to ensure material participation. Record keeping listing the type of work done and the amount of time spent is critical. If you want to show material participation in an activity, you must maintain time records, appointment book, or other written documentation.

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