Differentiate Between Active Income, Passive Income and Portfolio Income

Chapter Seven Questions/Problems

7. Differentiate between active income, passive income and portfolio income.

Active Income- This is the income an individual earns through participating in some activity with the goal of earning income. This is why the terms active income and earned income are often used interchangeably. For this to be active involvement the activity must be heavily used with the explicit purpose of gaining income. Examples of this are wages, salaries, tips or bonuses achieved during regular employment would all be active income.

Passive Income- This is income earned through a trade or investment in which the individual does not spend much time or effort. If this is the regular employment of the individual for which he/she is directly compensated it would be active income. For example, if an individual owns rental property, but hires an individual for the daily management of the property, any income derived would be passive income. This is true because the individual isn't constantly involved in daily operations of the rental investment.

Portfolio Income- This type of income is derived directly from investments such as stock earnings, mutual fund investments, or interest income. For example, if you receive dividends from a corporation for owning stock in that corporation it would be portfolio income since your investment portfolio is generating the income.

13. Briefly, what is "material participation"? Why is the determination of whether a taxpayer materially participates important?

Material participation is the point at which an individual becomes actively or continuously involved in a project. Earned revenue from the project is no longer considered passive income. This is important as this determines whether income is active or passive in consideration of how loses are deducted and how this income is taxed.

46. Mary Beth is a CPA, devoting 3,000 hours per year to her practice. She also owns an office building in which she rents out space to tenants. She devotes none of her time to the management of the office building. She has a property management firm make all management decisions for her. During 2012, she incurred a loss, for tax purposes, of $30,000 on the office building. How must Mary Beth treat this loss on her 2012 tax return?

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