Starting your rental business: Know the difference between active and passive income

Of course you’re becoming a landlord to make money, but part of your business’s success comes at tax time.  How you’re taxed — as active or passive income — makes a difference to your bottom line.  In future blogs, I’ll discuss how to determine if you qualify for active/material participation, and the advantages of either active and passive income.  But first, it’s important to understand what is meant by active and passive income.

The IRS defines the different types of income as follows (IRS-Passive Activity Losses-Real Estate Tax Tips, 27-Mar-2019):

Income and losses on a tax return are divided into two categories:

  • Passive: Rentals and businesses without material participation.  A limited partner is generally passive due to more restrictive tests for material participation.  As a result, limited partners will generally have passive income or losses from the partnership
  • Nonpassive: Businesses in which the taxpayer materially participates.  Also, salaries, guaranteed payments, 1099 commission income and portfolio or investment income are deemed to be nonpassive.  Portfolio income includes interest income, dividends, royalties, gains and losses on stocks, pensions, lottery winnings, and any other property held for investment

What does this mean in plain English?   If property management is your main business, and you spend a lot of time each year (750+ hours), your income is active (nonpassive).  If you spend little time on your rental properties and it’s not your main job, the income is passive.  But more on that in a separate blog!

Deciding on the kind of income (and therefore deductions) you’re after will help get your business off to the right start, both in determining your business structure and how hands-on your want to be.  So don’t neglect to think about what kind of income (and deductions!) will benefit you more come tax time.

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