Is rental income active or passive?

The Internal Revenue Service (IRS) categorizes rental income as either active or passive income. As a revenue stream, knowing whether your rental income is passive or active is crucial for tax purposes. 

You may be wondering, “Is my rental income active or passive?” We are here to help you understand the difference and highlight any exceptions to the rules. We also explain the tax requirements for passive rental income. 

What counts as rental income?

Rental income includes any payments you receive for the use or occupation of your rental property. This will include your regular rent payments, whether you accept them as flexible rent payments or split rent payments.

Here are the other examples of rental income:

• Advance rent payments. 
• Security deposits, if they are not returned to the tenant. 
• Fees for lease cancellations.
• Tenant-paid owner expenses, such as a tenant covering a repair bill that they deduct from their rent as this is your responsibility to cover.

Active vs passive rental income

Active income is money earned from activities in which you are heavily involved. This includes wages, salaries, and income from businesses where you actively participate in the day-to-day operations. For rental properties, if you spend significant time managing the property, it might be considered active income.

Passive income is earned with minimal effort or involvement. This includes earnings from rental properties where you do not significantly participate in management or operations. Most rental income falls into this category, as property managers typically handle the daily property activities.

Is rental income active or passive income?

Rental income is generally classified as passive income by the IRS. This classification is important because passive income is taxed differently than active income. However, there are some exceptions where rental income might be considered active.

Exceptions to the passive rental income rule

Whether rental income is passive or active is determined by the effort and management involved. Understanding these exceptions is crucial for accurate tax reporting and financial planning.

Here are the main exceptions:

Real estate professionals

Your rental income can be classified as active if you qualify as a real estate professional. To meet this qualification, you need to be spending more than 750 hours per year and over half of your working time on real estate activities. 

Material participation

If you are heavily involved in managing the rental property, your income might be considered active rather than passive. You would need to meet specific participation standards, such as spending more than 500 hours annually on rental property management activities. 

Substantial services

Providing significant services to tenants can make your rental income active due to the high level of involvement. These services can include running a bed and breakfast or offering daily cleaning. 

Is passive income taxable?

Passive income is taxable. However, the way passive income is taxed differs from active income.

Passive income from rental properties is included in your total taxable income and taxed at your regular income tax rate. You can deduct expenses related to the property, such as repairs and management fees, to reduce the taxable amount. 

Active rental income is taxed differently because it involves more direct participation. The deductions are similar, but active income comes with additional tax obligations due to the level of involvement in managing the property.

How is passive income taxed?

Passive income is taxed at the same rate as your regular income. When it comes to passive rental income, you can deduct a variety of operating expenses and losses to reduce your taxable income. 

Here are the common deductions you can claim:

• Property taxes
• Repairs and maintenance
• Utilities paid by the landlord
• Property management fees
• Marketing and advertising for tenants
• Homeowner association (HOA) fees
• Insurance premiums
• Legal and professional fees
• Travel expenses related to property management
• Supplies and equipment for property maintenance 

Using losses to offset passive income

Passive income losses can offset other passive income. If your rental property generates a loss, such as through higher operating expenses or vacancy, you can use that loss to reduce your taxable income. 

This is especially beneficial if you own multiple rental properties. For example, if one property generates a loss and another generates a profit, you can use the loss to offset the profit. However, passive losses cannot offset active income. 

It’s important to keep accurate records of all rental income and expenses. Proper documentation ensures you can take full advantage of tax deductions and comply with IRS regulations. Utilizing rent payment software can help you keep accurate records, making your tax season preparation easier and more efficient. 

How to report passive income from a rental property

Reporting passive income from a rental property involves several steps to ensure accuracy and compliance with tax laws. 

Here is a general step-by-step guide to help you through the process. If you are unsure about any step, consider consulting a tax professional. They can provide guidance and ensure you maximize your deductions and comply with IRS regulations.

1. Gather all income records

Collect all rent payment records, including advance rent and security deposits if applicable. Ensure all rent payments are documented correctly, possibly using rent payment software for accuracy.

2. Track deductible expenses

Maintain detailed records of all expenses related to the rental property. This includes property taxes, repairs, maintenance, and any other deductible costs.

3. Complete Schedule E (Form 1040)

Fill out Schedule E to report income and expenses for your rental property. You will need to list all rental income received and itemize each deductible expense.

4. Calculate depreciation

Depreciation allows you to deduct a portion of the property’s cost each year. Use the IRS guidelines to determine the appropriate depreciation method and amount.

5. Report total income and expenses

On Schedule E, subtract the total expenses from your total rental income to calculate your net rental income or loss. Ensure accuracy to avoid potential issues with the IRS.

6. Transfer figures to Form 1040

Transfer the net income or loss from Schedule E to your Form 1040. This figure is included in your total income for the year.

7. Keep detailed records

Maintain all documentation, receipts, and records for at least three years. This ensures you have proof of income and expenses in case of an audit.