What is passive income for tax purposes?

Passive income for tax purposes is specifically defined as income generated from rental activities or from business investments in which the taxpayer does not play an active role. This classification is crucial in determining how income is taxed and how losses can be utilized for tax purposes.

For instance, if an individual owns rental properties but does not manage them directly, the income from those properties qualifies as passive income. This is significant because passive income has specific tax treatment under the Internal Revenue Code, particularly in how it relates to the ability to offset other types of income such as ordinary wage income.

Understanding this distinction is essential for taxpayers engaged in real estate or other investment activities, as it can influence their overall tax strategy. It allows for the identification of which type of income might be subject to different rules, such as limitations on the ability to deduct losses from passive activities against other types of income. This is particularly important for those looking to maximize their tax efficiency and compliance.