What are passive income and losses?

Passive income and losses refer specifically to earnings derived from activities in which the taxpayer does not materially participate. This means that the taxpayer is not actively involved in the day-to-day operations or decision-making processes related to the income-generating activity. Common examples of passive income include rental income from real estate or earnings from a business entity where the taxpayer is a limited partner or does not hold a management role.

Understanding this definition is crucial because the IRS categorizes passive income and losses differently for tax purposes, particularly in regard to how they can offset other income types. Only certain limitations apply to how passive losses can be used to offset non-passive income, which can affect a taxpayer’s overall tax liability.

The other options focus on active participation in income-generating activities, such as providing services, selling goods, or earning royalties, which do not align with the definition of passive income and losses. Thus, recognizing the distinction between passive and active income sources is essential for accurately reporting income and losses on tax returns and maximizing potential deductions.