The IRS categorizes real estate investing and the income it generates into either active or passive income. Understanding these differences is crucial for real estate investors as it can greatly influence an investor's tax obligations and timelines for payment.
In this article, we delve into the differences between passive vs active income. Plus, we explore methods for calculating rental income and uncover exceptions to the rule regarding passive rental income.
Key takeaways
- Active real estate investing involves developing or flipping properties, while buy-and-hold investments yield passive income.
- Despite the common use of "passive" in real estate, few investments are entirely hands-off.
- Rental income is generally seen as passive, even if an investor actively manages the rental property business.
- Typically, passive income is subject to your usual marginal tax rate, which is based on your tax bracket.
Passive vs. active rental income
Engaging actively in the real estate business involves tasks like developing properties or flipping houses on a consistent, full-time basis. This requires continuous, dedicated effort from the investor.
In contrast, passive real estate income is generated through avenues like owning shares in a REIT, being a silent partner in real estate ventures, or holding rental properties without direct, full-time involvement. Passive investing in real estate is often seen as a supplementary endeavor rather than a primary occupation.
Is rental income passive or active?
Distinguishing between active and passive rental income can be perplexing because very few real estate investments, or investments in general, are completely hands-off. Even in scenarios like owning an out-of-state rental property, where investors might delegate day-to-day management to a local property manager, there's still substantial work involved, from assessing potential investments to overseeing tenant selection, ensuring timely rent collection, and of course financial management.
All these tasks lean more toward active involvement than passive investment. However, the IRS guidelines in IRS Publication 925 categorize rental activities as passive, even when an investor materially participates in them.
So, despite the hands-on engagement with rental property ownership and income collection, it's generally considered a passive activity by the IRS. However, there are exceptions to this classification that investors should be mindful of.
Exceptions to the passive rental income rule
In most scenarios, the IRS classifies rental income as passive income, but there are exceptions.
- If the rental property owner qualifies as a real estate professional by dedicating at least 750 hours yearly to real estate work, with over 50% of their overall work in real estate.
- When renting property to a company (e.g., LLC, S corporation) wherein the investor holds an interest, the IRS might classify the income as active.
- Income from short-term rentals (STRs) could be deemed active if the average tenant stay is 7 days or fewer.
- Rental income from a personal residence may become active if the home is a personal residence for over 14 days or 10% of the rented days.
Additional guidelines exist for distinguishing passive from active rental income, and seeking advice from a financial professional or tax advisor is advisable for personalized clarification in specific situations.
Is passive income taxable?
Yes. Passive income is subject to taxation by the IRS. Typically, this income is taxed at the same rates as those applied to regular job salaries and is dependent on your marginal tax bracket. However, leveraging tax deductions, especially in the cage of real estate, can help alleviate this tax liability.
Seeking advice from a tax professional can be beneficial for developing tax-saving strategies for your rentals. Their expertise can help tailor approaches to your specific circ*mstances, potentially optimizing your tax situation.
Related: Tax On Rental Income: How Much Tax Do You Owe?
How is passive income taxed?
Passive income is normally taxed at your usual marginal tax rate, the same rate as salaries received from a job. You’ll want to work with a tax professional to get a full view of your entire financial picture.
To calculate taxable passive rental income, follow these general steps:
- Total all rental income received, encompassing regular rent payments, application fees, late fees, and portions of refundable security deposits not returned due to property damage.
- Deduct operating expenses, covering various costs like advertising, leasing commissions, property management fees, repairs, landscaping, pest control, insurance, HOA fees, property taxes, and fees paid to real estate professionals.
- Subtract mortgage interest (excluding principal payments) if the property is financed, as the principal part doesn't count as an expense.
- Calculate annual depreciation expense by dividing the property's basis (purchase price minus land value, plus closing costs) by 27.5 years for residential properties. Capital improvements can increase the property's cost basis.
- Subtract the depreciation expense from the net operating income (income minus operating expenses and mortgage interest) to ascertain the taxable passive rental income.
Related: Passive Activity and Passive Activity Loss Limitations in Real Estate
Example of calculating passive rental income tax
Suppose an investor purchased a rental property for $200,000, with $20,000 attributed to the land value and closing costs.
- Rental income: $24,000
- Operating expenses: -$8,000
- Mortgage interest: -$5,000
- Net income before depreciation: $7,000
- Depreciation expense: ($180,000 property basis / 27.5 years): -$6,545
- Taxable passive rental income: $4,455
Assuming the investor falls under the 22% tax bracket, the taxes owed on this passive rental income would amount to $980.
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Using losses to offset passive income
In certain instances, an investor might face a loss for tax purposes due to vacancies or increased operating expenses.
For instance, considering the home from the earlier, but with a three month vacancy. The annual rental income would then be $18,000, operating expenses would be $8,000, this generates a passive rental income subject to a tax of -$1,545.
Losses incurred from rental properties can be offset against other positive passive income received in the same tax year, such as income from alternate rental properties or stock dividends. Any remaining loss can be carried forward to subsequent tax years to offset positive income.
How to report passive income from a rental property
Rental income finds its place on Schedule E (Form 1040), Supplemental Income and Loss, which attaches to an investor’s federal tax return. Though one can manually fill out Schedule E, accurately computing depreciation expenses can be intricate, leading to potential oversights in crucial deductions that reduce taxable net income.
Signing up for a free Landlord Studio account offers a straightforward method to automatically track income and expenses, manage rental property depreciation, and simplify tax preparations. By inputting the rental property address and linking bank and mortgage accounts, landlords can oversee the financial performance of individual properties and entire portfolios through a comprehensive owner dashboard.
Come tax season, the Landlord Studio Tax Center furnishes vital information, resources, and tax tools, including guidance developed in collaboration with The Real Estate CPA.
Final Words: Rental Income, Passive or Non-Passive
Investing in rental properties offers numerous advantages, such as steady cash flow, long-term equity growth, and specific tax perks. In most cases, rental income is considered passive for tax purposes, exempt from payroll taxes, with taxes determined by the investor's tax bracket. However, making sure you manage all of your rental property income and expenses is crucial.
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Purpose-built software like Landlord Studio plays a pivotal role in this realm. It ensures meticulous tracking of income and expenses, enabling landlords to minimize tax liabilities, stay on top of property expenses, and accurately report taxable income at year-end. Such tools not only simplify financial management but also maximize the benefits of owning rental properties while ensuring compliance with tax regulations.
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