Real estate investors love to talk about passive income. But what is passive income? Is there active income? This article is going to answer those questions and more.
Passive income includes rental net income, limited partnerships, and other enterprises in which the recipient of income from those sources is not materially participating. Such income is usually taxable but is treated differently by the IRS. That different treatment has guidelines for the recipient to consider:
- If you have dedicated 500 hours to a business or activity from which you are profiting, that is considered material participation.
- If your participation in that business or activity has been all the participation for that year, that is considered material participation.
- If you have participated up to 100 hours and that is as much as anyone else involved in the activity or business has participated, that is also considered material participation.
Thus, only truly investing in a business and stepping back to receive profits can be categorized as passive income. For example, if you put $25,000 into a business and the owners pay you a portion of the profits each year, then you have passive income. IRS Publication 925 sets out the specific criteria for passive income treatment, for those of you looking for further authority on this topic.
Passive income is taxed anywhere from 10% to 37%. Depending on what Congress does this year and during this administration, taxes may increase. While it may not feel like you are passively investing in your real estate activities, the IRS has concluded that unless activities are performed to fulfill responsibilities as a real estate professional, like a real estate agent or broker, those activities are passive.
More importantly, your passive income is only offset by passive deductions such as:
- Property management fees
- Maintenance and repairs
- Professional and legal fees
- Wages paid to a W-2 employee who receives a salary or hourly wage
- Advertising costs
- Tenant screening fees
- Commission, leasing, and referral fees
- Mortgage interest payments
- Property tax
- Insurance premiums
- License and registration fees
- Travel expenses directly related to the rental property
- Home office expense
- Office supplies
- Telephone and internet
- Dues and subscriptions for professional organizations such as a real estate investor club
- Continuing education expenses such as attending seminars or enrolling in courses and coaching
- Depreciation expense to reduce taxable income
- Pass-through tax deduction (or QBI deduction) of up to 20% of the net rental income, subject to certain limitations
Active income generally refers to wages, tips, salaries, commissions, and income from materially participating in activity or business. For purposes of real estate, there are two criteria that MUST be evaluated:
- More than half of the personal services the taxpayer performed in all trades or businesses during the year were performed in real property trades or businesses in which the taxpayer materially participated.
- The taxpayer performed more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participated.
Both of these criteria must be met. Moreover, IRS Section 469(c)(7)(A) and 26 CFR Section 469-9(g) require the taxpayer to make an election on their tax returns. Talk to your CPA or lawyer about these issues.
About the Author: Brian T. Boyd, JD, LLM, www.BoydLegal.co