What's the Difference Between Passive Income and Active Income for Tax Purposes?

The IRS distinguishes between active income and passive income, and the distinction affects how losses are treated on your tax return. Active income is money you earn by materially participating in a business or working — wages, self-employment income, and business profits where you're actively involved all count as active income. Passive income generally comes from activities you don't materially participate in, such as rental properties or limited partnership interests. The key tax difference is that passive losses can only offset passive income, not active income — so if your rental property generates a loss, you generally can't use it to reduce your regular wages. There are exceptions, including a $25,000 allowance for rental losses if your adjusted gross income is below $100,000 and you actively participate in managing the property.