Tax implications vary depending on classification. The Internal Revenue Service (IRS) classifies real estate investing and its generated rental income as either active or passive. In this blog, you’ll find the difference and exceptions to the passive rule.
Difference between Active and Passive Rental Income
Usually, active investing is when you work full-time and continuously on your business. Active investing in the real estate business includes:
- Real estate developing
- Fixing and flipping
On the other hand, passive income can be a project on the side instead of working on it full-time. Some examples of passive investing include:
- Owning shares of a real estate investment trust (REIT)
- A silent partner in a limited liability company (LLC)
- Buying and holding rental property
Is Rental Income Passive or Active?
Usually, rental income is considered passive earnings. Investing in real estate is generally deemed passive income, as you’re earning an income from an asset you’ve already invested in.
But rental income through real estate investments almost always involves active participation from the investor. Even if you hire a property manager who will take care of marketing, finding tenants, collecting rent, taking care of tenant communications, and overseeing repairs and maintenance, you’ll need to be involved.
You will need to check financial statements, speak to the property manager, and decide on repairs and refurbishments. But, the IRS views rental income as passive earnings even if you’re actively involved in real estate investments. In most cases, if you rent out properties to tenants, the IRS views this as passive income.
Though rental income is usually considered passive, the IRS has some guidelines for when rental income may be seen as active rather than passive.
Exceptions to the Passive Rental Income Rule
Rental income is seen as passive in most cases, but there are some exceptions to be aware of. Rental income is considered active if they fall under the below categories:
- The property owner is deemed a real estate investor, meaning you work 750 hours per year in the real estate business, with at least 50% of the work related to real estate.
- If the real estate is rented by a company like an LLC or S corporation whereby the investor holds a share.
- The real estate income may be considered active if the tenants’ average stay is less than seven days.
- Rental income from your personal residence can be considered active as long as you’re occupying the home for more than 14 days or 10% of the days it’s being rented out.
You may want to speak to a financial or tax advisor to understand if your rental income is active or passive. Special rules may apply to your specific situation.
How do Losses Work with Passive Income?
Depreciation can be one of the common causes of losing money from rental properties. If you lose money on an activity that earns passive income, it’s called a suspended loss. You can carry over the loss until you gain more passive income.
How to Report Passive Income from a Rental Property
You need to use Schedule E (Form 1040), Supplemental Income and Loss, to report the rental income.
You can fill out Schedule E yourself. But calculating depreciation expenses can be confusing, and you may miss eligible deductions for your taxable income. So, you may want to seek professional advice.
Tax Benefits of Passive Income
Generally speaking, the taxation of passive income falls under capital gains taxes. The passive income tax rate varies depending on whether the gain is considered long-term or short-term.
Short-term capital gains are taxed at the marginal income tax rate. Long-term gains are taxed at 0% to 20% based on your annual taxable income, marital status, and filing status. These are paid on profits from an asset held for over a year. Profits generated from an asset held for less than a year are considered short-term.
Many people know that rental income can be a great source of passive income, but not many people know of tax deductions that can make a difference in your rental income.
The IRS has several deductions you can use for rental property. The following is a list of passive income tax benefits you need to be aware of:
- You may be able to deduct the interest you pay on your mortgage every year.
- Any repairs necessary and within reason may be eligible for a deduction.
- If you travel to repair or do any maintenance on the property, you may be eligible to deduct the amount of money.
- You may be eligible to deduct your home office, given it meets the minimal criteria.
- Any loss made through depreciation on a rental property can be written off the cost of the home over a specific time.
Strategies to maximize rental income’s potential as passive income
Screen Tenants Thoroughly
One of the ways to maximize your passive income is by choosing the right tenants. A bad tenant can be more costly than any vacancy. They could damage your property, or you may have to deal with an expensive eviction process.
Ensure you spend some time screening your tenants and ensure you check their records and references.
Understand Landlord Responsibilities
Be prepared for the responsibilities that come with being a landlord. Often, beginner real estate investors don’t realize how tough it can be to be a landlord, so it’s essential to understand the responsibilities of a landlord. You should treat the rental property as a small business.
Collect Rent on Time
Set out clear rules and ensure tenants follow them. Some tenants may take advantage of your niceness and repeatedly pay rent late. Waiting too long to collect rent will impact your cash flow and delay the eviction.
Play an Active Role in Management
When managing a property correctly, you can reduce tenancy turnover, increase the property’s value, and avoid possible repair costs. Even if you hire a property manager, you should still stay active in managing the property by keeping in touch with tenants and taking care of the maintenance. This can be more time-consuming and costly, but worth it in the long run. When managing a property correctly, you can reduce tenancy turnover, increase the property’s value, and avoid possible repair costs.
Real estate rental income has many benefits, like consistent cash flow, profit from equity appreciation over the years, and tax benefits.
Mostly rental income is considered passive income for taxes and not liable to payroll tax. Taxes will be calculated depending on the investor’s tax bracket.
Asma is a freelance writer specialising in finance and business niche topics. Her experiences include working at one of the world’s oldest and largest asset management firms.
Apart from writing, Asma also enjoys reading about finance, business, and entrepreneurship.