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Is Rental Income Passive or Active? Understanding the Tax Implications

CEO Khai Intela
When it comes to real estate investing, understanding the classification of rental income as either passive or active is crucial. Not only does it affect the amount of taxes you have to pay, but it...

When it comes to real estate investing, understanding the classification of rental income as either passive or active is crucial. Not only does it affect the amount of taxes you have to pay, but it also determines when those taxes are due. In this article, we'll delve into the difference between passive and active rental income, how to calculate rental income, and exceptions to the passive rental income rule.

Passive vs. Active Rental Income

In the real estate business, active investing involves activities like developing properties, wholesaling, and fixing and flipping. These activities require full-time commitment and consistent effort. On the other hand, passive rental income is generated from buy-and-hold investments such as owning shares in a real estate investment trust (REIT), being a silent partner in a real estate syndication or limited liability company (LLC), or owning rental properties as a side gig rather than a full-time job.

The True Nature of Rental Income

It's important to note that although the term "passive" is often used to describe rental income, very few investments are truly entirely passive. Even for remote real estate investors who have a property manager overseeing the day-to-day operations, there is still a certain level of active participation required. Tasks like reviewing financial statements, making decisions on repairs or renovations, and visiting the property a few times a year are all part of the investor's responsibilities.

According to IRS Publication 925, rental income is considered passive even when an investor materially participates in the activity. As long as the property is used by tenants and rental income is received primarily for the use of the property, it is classified as passive income. This means that owning a rental property and collecting rental income is generally considered passive, regardless of the investor's level of involvement.

However, there are exceptions to this rule that investors should be aware of.

Exceptions to the Passive Rental Income Rule

While rental income is typically considered passive, there are a few scenarios where it may be treated as active income by the IRS. These include:

  • Real Estate Professional Classification: If the rental property owner meets certain criteria and is classified as a real estate professional, the income from the property may be considered active. To qualify as a real estate professional, one must work a minimum of 750 hours per calendar year in the real estate profession, with at least 50% of their work being in real estate.

  • Rental to a Company: If the property is rented to a company, such as an LLC or S corporation, in which the investor holds an interest, the rental income may be considered active.

  • Short-term Rentals: Rental income from short-term rentals (STRs) may be classified as active if the average period of a tenant's stay is 7 days or fewer.

  • Personal Residence: If a rental property is also used as a personal residence for more than 14 days or 10% of the days it is rented out, the rental income may be considered active.

It's important to consult with a financial professional or tax advisor to determine if any of these exceptions apply in your specific situation.

The COVID relief package, taxes, and real estate investors Image: The COVID relief package, taxes, and real estate investors

How Passive Rental Income is Taxed

Taxes must be paid on rental income, whether it is considered active or passive. However, the way taxes are calculated and paid differs for each type of income. Active rental income is generally subject to payroll taxes, such as Social Security, Medicare, and federal and state unemployment taxes, because it is generated from work done. On the other hand, passive income comes from investments, similar to receiving stock dividends.

To calculate taxable passive rental income, follow these general steps:

  1. Calculate all rental income received: This includes monthly rent payments, application fees, late fees, and any portion of the tenant's security deposit that is not returned.

  2. Subtract operating expenses: Deduct expenses such as advertising fees, property management fees, repairs and maintenance costs, property taxes, and professional service fees.

  3. Subtract mortgage interest: If the property is financed, deduct the mortgage interest paid.

  4. Determine net income before depreciation expense: Subtract operating expenses and mortgage interest from total rental income.

  5. Calculate annual depreciation expense: Divide the property basis by 27.5 years for residential income property. This includes the purchase price, closing costs, and capital repairs that increase the property basis.

  6. Subtract depreciation expense from net income: This will give you the passive rental income that is subject to tax.

For example, let's say your rental income is $15,000, operating expenses amount to $6,000, mortgage interest is $4,320, and depreciation expense is $4,000. The taxable passive rental income would be $680. If you are in the 22% tax bracket, you would owe $149.60 in taxes on this income.

Using Losses to Offset Passive Income

In cases where a rental property generates a loss for tax purposes, such as when rental income is lower than expected or operating expenses are higher, you may be able to offset the loss against other positive passive income. This includes income from other rental properties or stock dividends. If there is still a remaining loss, it can be carried over to future tax years and used to offset positive income.

Reporting Passive Income from Rental Property

Rental income must be reported on Schedule E (Form 1040), which is attached to your federal tax return. While it is possible to fill out Schedule E manually, calculating depreciation expenses can be complicated, and overlooking valuable deductions is easy. To simplify the process, consider signing up for a free account with Stessa. They offer automated income and expense tracking, depreciation calculations, and a comprehensive owner dashboard. The Stessa Tax Center provides a personalized tax package and other tax resources, including information created in partnership with The Real Estate CPA and a TurboTax discount exclusively for Stessa Community members.

Closing Thoughts

Investing in rental property has many benefits, including recurring cash flow, long-term equity appreciation, and unique tax advantages. In most cases, rental income is treated as passive income for tax purposes and is not subject to payroll taxes. However, it's essential to understand the exceptions and consult with a professional to ensure compliance with tax regulations.