Real estate investing and the rental income generated can be classified as either active income or passive income by the IRS. This classification is crucial because it significantly affects the amount of taxes an investor must pay and when they must pay them. In this article, we will explore the differences between passive and active rental income, how to calculate rental income, and the exceptions to the passive rental income rule.
Passive vs. active rental income
Active real estate investing involves activities such as developing properties, wholesaling, and fixing and flipping. It usually requires full-time and continuous work from the investor. On the other hand, investors can earn passive rental income by owning shares in a real estate investment trust (REIT), participating as a silent partner in a real estate syndication or limited liability company (LLC), or owning and renting out properties as a side gig.
Is rental income passive or active?
One of the confusing aspects of rental income is that even though it is often referred to as "passive," there is usually some level of active participation from the investor. For example, even if an investor hires a property manager to handle the day-to-day tasks of managing a rental property remotely, they still need to review financial statements, make important decisions, and occasionally visit the property.
However, according to IRS Publication 925, rental income is generally considered passive, even if the investor materially participates in the activity. The IRS defines rental activity as passive if the property is mainly used by tenants and the income is received mainly for the use of the property. So, in most cases, owning a rental property and collecting rental income is classified as passive.
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 exceptions. These include:
- The rental property owner is classified as a real estate professional, meeting specific requirements set by the IRS.
- The 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 may be considered active if the average tenant stay is 7 days or fewer.
- Rental income from a personal residence may be active if the home is occupied for more than 14 days or 10% of the days it is rented out.
It's important to note that there are additional guidelines to determine whether rental income is passive or active. Seeking advice from a financial professional or tax advisor is recommended to understand how these rules apply in individual situations.
How passive rental income is taxed
Taxes must be paid on rental income, regardless of whether it is classified as active or passive. However, the tax treatment differs between the two. Active rental income is subject to payroll taxes, such as Social Security, Medicare, and federal and state unemployment taxes, as it is considered income generated from work. In contrast, passive income is derived from investments and is similar to receiving stock dividends.
Here are the general steps to calculate taxable passive rental income:
- Calculate all rental income received, including rent payments, applications, late fees, and part of a tenant's security deposit.
- Subtract operating expenses, such as marketing fees, property management fees, repairs, landscaping, insurance, and property taxes, from the total income received.
- Deduct mortgage interest payments if the property is financed.
- Determine net income before depreciation expense by subtracting operating expenses and mortgage interest from total rental income.
- Calculate annual depreciation expense based on the property basis divided by the useful life of the property (27.5 years for residential income property).
- Subtract depreciation expense from net income to determine the taxable passive rental income.
Here's an example to illustrate the calculation:
Rental income: $15,000 Operating expenses: -$6,000 Mortgage interest: -$4,320 Net income before depreciation expense: $4,680 Depreciation expense: -$4,000 Passive rental income subject to tax: $680
If an investor is in the 22% tax bracket, the taxes due on the passive rental income would be $149.60.
It's worth noting that in cases where a property generates a loss for tax purposes, such as when rental income is lower than expected or expenses are higher, these losses can be used to offset other positive passive income received in the same tax year. Any remaining losses can be carried over to future tax years to offset positive income.
How to report passive income from a rental property
Rental income should be reported on Schedule E (Form 1040), Supplemental Income and Loss, which is attached to an investor's federal tax return. While it's possible to fill out Schedule E manually, it can be complicated to calculate depreciation expenses accurately and easy to overlook valuable deductions that can reduce taxable net income. Using tools like Stessa can simplify the process by automatically tracking income and expenses, calculating depreciation, and providing comprehensive tax resources.
Closing thoughts
Investing in rental property offers various benefits, including recurring cash flow, equity appreciation, and unique tax advantages. For tax purposes, rental income is generally treated as passive income and is not subject to payroll taxes. However, it's essential to understand the specific rules and exceptions that apply to ensure compliance and optimize tax planning. Seeking guidance from financial professionals or tax advisors can help investors navigate the complexities of rental income taxation.