The three generally acknowledged income categories are active, passive, and portfolio income. While active income (also called ordinary or earned income) results from active participation in an endeavor, such as wages from a job, passive income is derived from activities requiring minimal taxpayer effort. Passive sources of income may come from rental properties (but not always), partnerships in a business, and royalties. Portfolio income includes dividends, interest, and capital gains.
Typically, each type of income can be offset only by the same kind of loss, but there are exceptions.
One great example of passive income is investing in a business. Suppose you invest money into a company that you will not be involved with managing. If you receive a return from your investment, like a share of the profits, that is passive income. If you invest in a business and don’t actively participate, but the venture loses money, that is a passive loss. Passive income can be offset by passive losses when you file taxes.
If you write a book, that is active work, and the income is ordinary. However, if you later receive royalties from subsequent sales, that royalty income is passive.
Real estate activities can be passive or active. Suppose you own several residential rental properties that you engage a property manager to operate. In that case, the income you receive is passive because you didn't actively participate in the leasing, repairs, maintenance, etc. On the other hand, if you do the maintenance and repairs, find and qualify the tenants, collect the rents, and respond to the late-night calls for plumbing issues, that is active involvement.
If the rental income is passive, the rule to apply is that passive losses offset passive income. Up to $25,000 of losses can offset ordinary income if the rental activity is active. However, this particular offset is only available to taxpayers with low MAGI (Modified Adjusted Gross Income). The maximum MAGI for a taxpayer filing individually is $100,000.
Suppose you have a loss of $10,000 from an investment into a partnership but only $5,000 of passive income from your DST investment. In that case, you can carry the remainder of the loss forward and use it to offset passive losses in future tax years.
Sometimes, a real estate investor will have a paper loss for a property with positive cash flow. This outcome results from depreciation, which is an integral part of the calculus for rental property. For example, suppose you have rentals with a net operating income of $5,000 per month.
If you have a depreciation deduction for the property that is greater than $60,000, you have a loss for that year, even though you have positive cash flow. That loss can be used to offset passive income from other sources.
Keep in mind that if you sell the property for more than the depreciated amount, you will owe a depreciation recapture tax, along with taxes on any capital gains.