The Tax Reform Act of 1986 divides a taxpayer’s income into three categories:
1. Active income: wages and salaries
2. Portfolio income: income from interest, dividends, annuities, or royalties
3. Passive income: income from a trade or business in which the taxpayer does not materially participate
Income of a limited partner, member, or shareholder in a direct participation program is considered passive income, as is any income derived from rental properties.
The passive activity loss rule prevents a taxpayer from deducting passive activity losses from income that is derived from any other source than another passive activity. In other words, aggregate losses from all passive activities cannot be used for tax purposes to deduct other income.
IRC Section 469
Example: Shirley’s gross income includes a salary of $150,000, $30,000 in short-term realized capital gains from her portfolio of stocks, and $20,000 from her investment in BetCo oil and gas, a DPP. She also has incurred losses from an investment in a real estate DPP equal to $40,000. She deducts her passive activity losses from her passive activity income, leaving her with an adjusted gross income of $180,000, taxable at the ordinary income rate.
