What is Portfolio Income?

Categories of Income

There are three categories of income:

  1. Earned income (also called active income).
  2. Portfolio income
  3. Passive income

Earned Income

Wages from a job and income from a business that you own and actively participate in are examples of earned income.

Portfolio Income

Portfolio income is derived from various types of investments, such as stocks, bonds, mutual funds, and annuities. The income from these types of investments include, interest, dividends, and capital gains. Royalties from property held for investment are also portfolio income.

You may not deduct passive losses from portfolio income.

Portfolio income earned by the activity is excluded from the determination of passive income or loss. In addition, expenses related to portfolio income are also excluded from the computation of passive income or loss.

Interest received on business accounts receivable is not treated as portfolio income. Report such interest as other income.

You add items included in other income to gross receipts derived from the primary activity of the business.

Passive Income

Here's how Section 469(c) of the Internal Revenue Code defines a passive activity:

In general - The term "passive activity" means any activity which involves the conduct of any trade or business, and in which the taxpayer does not materially participate.

Therefore, passive income is derived from activities in which you do not materially participate. Rental income from a house or condominium you own or income from a partnership in which you are a limited partner are examples of passive income.

Special $25,000 Loss Exception for Real Estate Non-profressionals (also called The Small Landord Exception)

Although rental activities are always considered passive activities (except for real estate professionals), a special rule, referred to as the small landlord exception, allows real estate non-professionals to classify up to $25,000 of rental losses as nonpassive. In other words, up to $25,000 may be deducted from other income reported on Form 1040, such as wages, dividends, and interest.

To qualify for this exception, you must actively participate in the activity. But it's fairly easy to qualify for this exception.

As long as a taxpayer participates in management decisions in a bona fide sense, he actively participated in the real estate rental activity. For example, approvng tenants, setting the rental, approving maintenance and repairs.

There is no specific hour requirement. However, the taxpayer must be exercising independent judgment and not simply ratifying decisions made by a manager.

Several categories of taxpayers do not meet the standard of active participation and therefore do not qualify for the $25,000 special allowance:

  • A limited partner in an activity (IRC § 469(i)(6)(c)).
  • A taxpayer who has less than 10 percent ownership (IRC § 469(I)(6)(A)).
  • A trust or corporation.  The $25,000 is available only to natural persons. 

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