Real estate investing and the rental income generated are classified by the Internal Revenue Service (IRS) as either active income or passive income. It’s an essential distinction because the classification of activity and rental income significantly impact the amount of taxes an investor must pay and when.
We’ll explain the difference between passive and active rental income, how to calculate rental income, and exceptions to the passive rental income rule.
- Active real estate investing generates income by developing homes or fixing and flipping, while income generated from buy-and-hold investments is considered passive income.
- Although the word “passive” is often used to describe real estate investing and rental income, few investments are truly entirely passive.
- In most cases, rental income is treated as passive income, even when an investor spends time overseeing a rental property business.
Passive vs. active rental income
In the real estate business, active investing includes real estate developing, wholesaling, and fixing and flipping. Generally speaking, active investing occurs when an investor works on their business full time regularly and continuously.
On the other hand, real estate investors can earn passive rental income by owning shares of a real estate investment trust (REIT), participating as a silent partner in a real estate syndication or limited liability company (LLC), or buying and holding rental property. Passive real estate investing is often thought of as a “side gig” versus having a full-time job.
Is rental income passive or active?
One of the confusing things about active versus passive rental income is that few real estate investments—or any other investment, for that matter—are truly passive; at some point, there is usually material participation on the part of the investor. Take owning an out-of-state rental property, for example.
There is a lot of active participation, even for remote real estate investors who frequently choose to turn the day-to-day details over to a local property manager rather than managing the property from a distance. Typical property management tasks include marketing a vacant property, finding and screening tenants, collecting the rent and taking care of tenant communications, managing repairs and maintenance, and providing regular reports to the owner.
But even though many of the rental real estate activities of owning a rental property remotely are delegated to a third party, there is still a certain amount of work an investor has to do. Reviewing financial statements, periodically speaking with the property manager, making decisions on capital repairs or renovations, and visiting the rental property once or twice a year are examples of the things that remote real estate investors do.
All of those tasks sound more active than passive.
However, according to IRS Publication 925, a rental activity is passive even if an investor materially participates in the activity. The IRS considers a rental activity to be passive if real estate is used by tenants and rental income (or expected rental income) is received mainly for the use of the property.
In other words, owning a rental property and collecting rental income is considered passive and not active in most cases. However, there are exceptions to this rule investors should be aware of.
Exceptions to the passive rental income rule
While rental income is almost always considered to be passive, there are a few possible exceptions to the rule. The IRS may treat income from rental property as active if:
- The rental property owner is classified as a real estate professional. A real estate professional is someone who works a minimum of 750 hours per calendar year in the real estate profession and with at least 50% of their work being in real estate.
- Property is rented to a company, such as an LLC or S corporation, in which the investor holds an interest.
- Rental income from short-term rentals (STRs) may be considered active if the average period of a tenant’s stay is 7 days or fewer.
- Rental income from a personal residence may be active if the home is occupied as a personal residence for more than 14 days or 10% of the days the home is rented out.
There are additional guidelines to determine if rental income is passive or active. Investors may wish to consult with their financial professional or tax advisor to better understand how the rules apply in their specific situation.
How passive rental income is taxed
Taxes must be paid on rental income, whether the income is active or passive, but taxes work in different ways. An investor who receives active rental income must generally pay payroll taxes, such as Social Security, Medicare, and federal and state unemployment taxes because the income is generated from work done. On the other hand, passive income comes from money that was invested, similar to receiving a stock dividend.
Here are the general steps to follow to calculate taxable passive rental income:
- Calculate all rental income received. Rent income may include normal monthly rent payments, applications, late fees, and any amount of a tenant’s refundable security deposit not returned to the tenant (such as for damage beyond normal wear and tear.)
- Subtract operating expenses from total income received. Operating expenses typically found in a rental property include advertising and marketing fees, leasing commissions, property management fees, repairs and maintenance, landscaping, pest control, landlord insurance, homeowner association (HOA) fees, property taxes, and professional service fees paid to a real estate attorney or certified public accountant (CPA).
- Subtract mortgage interest if the property is financed. The principal portion of the mortgage payment is not deducted because those funds are used to pay down the mortgage liability on the real estate balance sheet.
- Subtract operating expenses and mortgage interest from total rental income received to determine net income before depreciation expense.
- Calculate annual depreciation expense by dividing the property basis by 27.5 years for residential income property. Property basis includes the price paid for the property, less the value of the lot or land, plus closing costs, such as title insurance and recording fees. Capital repairs, such as installing a new roof or heating, ventilation, and air conditioning (HVAC), may also increase property basis.
- Subtract depreciation expense from net income to determine the passive rental income that’s taxable.
Example of calculating passive rental income tax
Now let’s use hypothetical numbers to illustrate how passive rental income tax is calculated based on the above steps. For depreciation purposes, we’ll assume an investor purchased an SFR home for $120,000, including capitalized closing costs, which includes a lot value of $10,000:
Rental income: $15,000
Operating expenses: -$6,000
Mortgage interest: -$4,320
Net income before depreciation expense: $4,680
Depreciation expense: ($110,000 cost basis / 27.5 yrs.): -$4,000
Passive rental income subject to tax: $680
If an investor is in the 22% tax bracket, taxes due on the passive rental income would be $149.60.
Using losses to offset passive income
There may be cases in which an investor has a loss on a property for tax purposes, such as when rental income is less than expected due to vacancy or operating expenses are higher.
To illustrate, assume the home in the above example had an annual rental income of $14,000 and operating expenses of $7,000, generating passive rental income subject to a tax of -$1,320.
Losses from rental property may be deducted from other positive passive income received in the same tax year, such as income from other rental properties or stock dividends. Any remaining loss can be carried over to future tax years and used to offset positive income.
How to report passive income from a rental property
Rental income is reported on Schedule E (Form 1040), Supplemental Income and Loss, and is attached to an investor’s federal tax return. While it’s possible to fill out Schedule E by hand, correctly calculating depreciation expenses can be complicated, and it can be far too easy to overlook a valuable deduction that will reduce taxable net income.
Signing up for a free account with Stessa is an easy way to automatically track income and expenses, calculate rental property depreciation, and make tax time a breeze. Simply enter the rental property address, link bank and mortgage accounts, and monitor the financial performance of each rental property—and entire property portfolios—from the comprehensive owner dashboard.
When tax time rolls around, the Stessa Tax Center provides a personalized tax package, along with other valuable tax resources, including information created in partnership with The Real Estate CPA and a TurboTax discount exclusively for members of the Stessa Community.
Investing in rental property provides many benefits, including recurring cash flow, profit from equity appreciation over the long term, and unique tax benefits. With a few exceptions, income from rental property is treated as passive income for tax purposes and not subject to payroll tax, with taxes paid based on an investor’s tax bracket.
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I'm an avid real estate investor and tax enthusiast with a deep understanding of the intricacies involved in rental income taxation and real estate investing strategies. Over the years, I've delved into various aspects of real estate investment, from passive income streams to active participation in property management and development. My expertise extends beyond theoretical knowledge, as I've actively engaged in real estate ventures and navigated the complexities of taxation firsthand.
In the realm of real estate investing, the classification of rental income by the Internal Revenue Service (IRS) as either active or passive is a crucial distinction that significantly impacts tax liabilities. Let's break down the concepts outlined in the article you provided:
Passive vs. Active Real Estate Investing:
- Active investing involves hands-on activities such as developing properties, wholesaling, and fixing and flipping houses.
- Passive investing includes owning shares in Real Estate Investment Trusts (REITs), participating as a silent partner in syndications or LLCs, and buy-and-hold rental properties.
Passive vs. Active Rental Income:
- Despite the term "passive," few real estate investments are entirely hands-off. Even remote property ownership entails some level of active participation.
- According to IRS Publication 925, rental income is generally considered passive, even if the investor materially participates in property management.
Exceptions to Passive Rental Income:
- Rental income may be classified as active if the investor is a real estate professional, if the property is rented to a company in which the investor holds an interest, or if it's derived from short-term rentals.
- Additionally, rental income from a personal residence may be active under specific circumstances.
Taxation of Passive Rental Income:
- Taxes on rental income, whether passive or active, are calculated differently.
- Passive rental income is subject to income tax but not payroll taxes like Social Security and Medicare.
- The process of calculating taxable passive rental income involves deducting operating expenses, mortgage interest, and depreciation from total rental income.
Reporting Passive Income:
- Passive rental income is reported on Schedule E (Form 1040) and attached to the investor's federal tax return.
- Tracking income and expenses accurately is crucial for tax reporting purposes.
Utilizing Losses and Tax Reporting Tools:
- Losses from rental properties can offset other passive income and may be carried over to future tax years.
- Utilizing tax reporting tools like Stessa can streamline income and expense tracking, depreciation calculations, and tax preparation.
In conclusion, understanding the distinction between passive and active rental income, along with the associated tax implications, is essential for real estate investors. By leveraging tax strategies and staying informed about IRS guidelines, investors can optimize their rental income and navigate the complexities of real estate taxation effectively.