How is Passive Real Estate Income Taxed?

Passive real estate income is an investment approach where individuals acquire assets that generate revenue without requiring the same level of hands-on effort as a typical job. The appeal lies in its ability to create a steady stream of income that can supplement a primary salary or become a main source of financial support. Understanding the tax implications of this income is a component of successfully managing these investments.

Defining Passive Activity in Real Estate

For tax purposes, the term “passive” has a precise legal definition. The Internal Revenue Service (IRS) distinguishes between passive and non-passive activities based on “material participation.” If an individual materially participates in a real estate enterprise, the activity is not considered passive. The IRS provides seven tests to measure material participation, and meeting the criteria for any one of these classifies the taxpayer as a non-passive participant for that activity.

One common test is whether the individual spends more than 500 hours during the tax year on the activity. Another examines if the individual’s participation constitutes substantially all of the participation for the tax year. A third measures if the individual participates for more than 100 hours, and that participation is not less than any other individual’s. These tests require careful record-keeping, as the burden of proof is on the taxpayer to substantiate their involvement.

The framework is designed to prevent taxpayers from using losses from certain investments to offset their primary earned income. For most real estate investors, rental activities are automatically considered passive unless they qualify for a special exception. Without a clear understanding of these material participation rules, investors may misclassify their income, leading to incorrect tax filings and potential penalties.

Methods for Generating Passive Real Estate Income

Direct Ownership of Rental Properties

A traditional method for generating real estate income is through the direct ownership of rental properties. In this model, an investor purchases a residential or commercial property and leases it to tenants for regular rental payments. The income generated is the gross rent collected, from which the owner pays for expenses like the mortgage, property taxes, insurance, and property management fees. The remaining amount constitutes the net cash flow.

Real Estate Investment Trusts (REITs)

Real Estate Investment Trusts (REITs) offer a way to invest in a portfolio of real estate assets without directly owning or managing any properties. A REIT is a company that owns, operates, or finances income-producing real estate. By purchasing shares in a REIT, an investor receives a portion of the income produced by the underlying properties, typically as dividends. Investors in REITs benefit from the diversification of a large portfolio, which can help mitigate the risks associated with owning a single property.

Real Estate Crowdfunding Platforms

A more modern approach is through crowdfunding platforms, which pool capital from many individuals to fund real estate projects. Investors can choose specific projects to back and contribute a smaller amount of capital than would be required to purchase a property outright. The platform handles all aspects of the investment, from acquisition to management. The income is typically distributed as a share of the rental income or profits from the property’s eventual sale.

Real Estate Limited Partnerships (RELPs)

In a Real Estate Limited Partnership (RELP), general partners manage the real estate projects, while limited partners contribute capital but have no involvement in management. The income for limited partners is their share of the profits generated by the partnership’s real estate activities. This structure allows investors to benefit from the expertise of the general partners while limiting their own liability to the amount of their investment.

Tax Treatment of Passive Real Estate Income

The tax treatment of passive real estate income is governed by a specific set of rules. For individuals who directly own rental properties, the income and expenses are reported on Schedule E of Form 1040. This form allows taxpayers to list their total rental income and subtract associated deductible expenses, which can reduce the amount of taxable income from the property.

Commonly deducted expenses for rental properties include mortgage interest, property taxes, insurance, and the costs of maintenance and repairs. For larger expenditures that improve the property, such as a new roof, the cost is capitalized and depreciated. Depreciation is a non-cash deduction that allows property owners to recover the cost of a building over its useful life, which the IRS sets at 27.5 years for residential rental properties.

A primary component of passive real estate taxation is the Passive Activity Loss (PAL) rules. These rules state that losses from passive activities can only be used to offset income from other passive activities. This means if a rental property generates a net loss, that loss cannot be used to reduce taxable income from non-passive sources, such as a salary. This limitation is designed to prevent taxpayers from using real estate losses as a tax shelter.

If a taxpayer has passive losses that exceed their passive income, the excess loss is suspended and carried forward to future tax years to offset future passive income. If the taxpayer sells the property that generated the losses, any suspended losses associated with that property are released. These released losses can then be used to offset any type of income.

Special Tax Considerations

Net Investment Income Tax (NIIT)

Some passive real estate income may be subject to the Net Investment Income Tax (NIIT). This is a 3.8% tax that applies to certain net investment income for individuals, estates, and trusts with income above statutory thresholds. For 2024, the NIIT applies to individuals with a modified adjusted gross income (MAGI) exceeding $200,000 for single filers or $250,000 for married couples filing jointly.

Net investment income includes rental income and income from businesses that are considered passive activities. This additional tax can have a meaningful impact on the after-tax returns of an investment. The NIIT is reported on Form 8960, which is filed with the taxpayer’s annual income tax return.

Real Estate Professional Status

An exception to the PAL rules exists for individuals who qualify as real estate professionals. This status allows a taxpayer to treat their rental real estate activities as non-passive, meaning they can deduct losses from these activities against other non-passive income. To qualify, an individual must meet two IRS tests.

The first test requires that more than half of the personal services the taxpayer performs in all businesses during the year are in real property trades in which they materially participate. The second test requires the taxpayer to perform more than 750 hours of services during the tax year in those same real property trades. Meeting these requirements provides a substantial tax advantage for those heavily involved in the real estate industry.

1031 Exchange

A 1031 exchange, or like-kind exchange, is a tax-deferral strategy that allows an investor to postpone paying capital gains taxes on the sale of an investment property by reinvesting the proceeds into a new, “like-kind” property. The term “like-kind” is broadly defined, but both properties must be held for investment or for productive use in a trade or business.

To execute a 1031 exchange, an investor has 45 days from the sale date of the original property to identify potential replacement properties. They then have 180 days from the original sale date to close on the purchase of one or more of those properties. This strategy defers the capital gains tax, allowing the investor to grow their portfolio without an immediate tax liability. The deferred gain is rolled into the new property and will be recognized when the replacement property is eventually sold.