Rental real estate activities are generally considered rental activity, not a trade or business, so they are passive activities by default. However, if you are engaged in the management of the property, you will be considered a material participant and your rental income will be treated as active income.
Rental property is a great investment, but it has its ups and downs. In this post, we’ll take a look at the differences between active and passive rental income to help you decide which one is right for you.
Passive vs. Active Rental Income
What is passive rental income?
Passive rental income is the rental income that you do not actively work to generate. Most people think of this as simply being the rent they receive from their tenants. Passive rental income, however, encompasses any type of rental income that you do not have to work for.
There are many different types of rental properties that can provide passive rental income, including residential and commercial properties. In some cases, it might even be possible to receive passive rental income from an investment property that is being rented by a tenant who is paying their own expenses, such as utilities and repairs.
For example, if you own a vacation home and leave it vacant most of the year, that’s passive rental income. If you own a commercial property and it’s leased out to tenants but you don’t have to do anything else in order for them to pay rent, that’s passive rental income too.
Advantages of passive rental income:
Passive rental income is a great way to make money in real estate. You can earn a potentially high return on your investment while you sleep and do other things. Here are some of the advantages:
Low maintenance: Passive rental income properties don’t require as much work as active ones. You don’t have to worry about finding tenants, collecting rent or repaying the mortgage.
Tax benefits: There are numerous tax benefits associated with passive rental income, including depreciation, tax-free capital gains and more.
Easily diversified: Passive rental income can be spread across different types of properties and geographic locations. This helps to protect your assets from any one market downturn or economic event.
What is active rental income?
Active rental income is when you manage your property yourself. This can include everything from finding tenants, screening them, collecting rent, managing maintenance needs and more.
Advantages of active rental income:
You can keep more of your profits because you control all aspects of the property management process. This means there’s no third party taking a cut of your profits like they would with a property management company.
You have complete control over how much effort goes into managing your properties and how much time they take up in your day-to-day life. If you want to spend less time on maintenance issues and more time enjoying life, active management will allow that for you.
Exceptions to the passive rental income rule
There are several exceptions to the passive rental income rule.
The first is for real estate professionals. If your rental property is a part of your business, then you can deduct losses from that rental property, just like any other business expense.
The second exception is if you have a loss on the sale of your personal residence. You can only deduct up to $250,000 of losses on the sale of a primary residence — even if it’s not a rental property.
The third exception is if you live in the home and use it as a primary residence during the time you own it. In this case, you can deduct mortgage interest and real estate taxes paid on the property while you owned it — as long as they’re not reimbursed by an employer or another person who may have an interest in the property.
How passive rental income is taxed
The tax rate for passive rental income depends on whether it constitutes portfolio or non-portfolio investment property (NPI). Portfolio NPI can be either residential or commercial real estate and includes any buildings that are not used as a principal residence or business office. Non-portfolio NPI consists of all remaining types of NPI such as timberland, oil and gas interests, and real estate investment trusts (REITs).
The following steps will help you calculate your passive rental income:
- Calculate gross rental income by adding up all the money you earned from renting out your property.
- Subtract any money spent on operating and maintaining the property, such as property taxes, insurance and repairs. You can deduct these costs even if they were paid by a third party, such as an insurance company or a tenant’s association.
- Subtract any debt payments made for the benefit of the property, such as mortgage interest or loan principal payments made on behalf of the borrower by a lender or third party.
- Determine whether any expenses are deducted from the property’s gross income to arrive at its net income in order to calculate your net passive income by subtracting those expenses from your gross income amount before calculating taxes on passive rental income.
Example of calculating passive rental income tax
Passive rental income tax is calculated as follows:
Gross Rental Income (GROSS) – Allowable deductions = Net Rental Income (NRI).
NRI * 0.15 = Passive Rental Income Tax (PRIT).
The allowable deductions are:
Interest on loans used to acquire or improve property
Repairs and maintenance costs (including depreciation of assets)
Management fees and other payments paid to third parties to operate the property.
How to calculate property value based on rental income
Calculating a property’s value based on its rental income is a way to determine whether the price of an investment property is worth buying. The process requires a few calculations and the use of a spreadsheet or calculator to determine how much rent you can charge, what your expenses will be and what profit you can make. The formula is simple:
- Calculate net operating income. This is the amount left over after subtracting all expenses from your monthly rent. The figure should be net of any expenses related to the management or maintenance of the building, as well as taxes and insurance.
- Subtract vacancy and collection costs from net operating income to determine gross revenue. Vacancy refers to empty units that have not been rented; collection costs cover late payments, damages and other fees associated with collecting rent from tenants.
- Multiply gross revenue by an appropriate multiplier to arrive at market value (or fair market value). Multipliers vary depending on location and type of property, but for single-family homes in some areas it may be 1.25 times annual rents; for multifamily buildings, it may be 1.5 times annual rents; for retail space, it may be 2 times annual rents; for industrial space, it may be 3 times annual rents;
Closing thoughts
As you can see, determining whether or not rental income is passive or active is a complicated process. It’s also complicated by the fact that the IRS continually updates their standards. If you’re considering rental income, it’s important to work with a good tax preparer who can keep you informed of any changes that might affect your taxes.
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