The purpose of the passive loss rules is to prevent you from deducting passive losses from nonpassive income. Passive losses are losses from business activities in which you do not materially participate (10.6) or losses from rental activities that are not deductible under the $25,000 allowance (10.2) or which do not qualify you as a real estate professional (10.3). In some cases passive income may be recharacterized as nonpassive income (10.9).
Where you do not materially participate in a business activity, passive income or loss is determined by matching income and expenses of that activity. Portfolio income (see below) earned by the activity or any pay that you earn is not included to determine passive income or loss.
Portfolio income is nonpassive income and broadly defined as income that is not derived in the ordinary course of business of the activity. Portfolio income includes interest, dividends, annuities, and royalties from property held for investment. However, interest income on loans and investments made in the business of lending money or received on business accounts receivable is generally not treated as portfolio income; see 10.9 for special recharacterization rules. Similarly, royalties derived from a business of licensing property are not portfolio income to the person who created the property or performed substantial services or incurred substantial costs.