How Is Passive Rental Income Taxed?

Understanding the tax treatment of rental income is important for property owners. This article clarifies the tax implications for passive rental income.

What Is Passive Rental Income

The Internal Revenue Service (IRS) categorizes income from rental activities as generally passive. This classification applies to activities where the taxpayer does not materially participate in the operation of the rental property. Material participation typically involves regular, continuous, and substantial involvement.

Even if a property owner is actively involved in managing their rental property, IRS rules often default rental activities to a passive classification. This distinction is crucial because it affects how any losses generated from the rental activity can be used for tax purposes. For example, owning a residential house and renting it out, or holding a commercial building for lease, are common scenarios considered passive income.

Passive activities are distinct from non-passive income sources, such as wages, salaries, or income from a business in which one materially participates. This separation prevents losses from passive ventures from automatically offsetting other types of income. Most rental real estate activities, by their nature, fall under the passive income umbrella.

Common Deductible Rental Expenses

Property owners can deduct ordinary and necessary expenses incurred in operating the property. An expense is considered ordinary if it is common and accepted in the rental real estate business, and necessary if it is helpful and appropriate for that business. These deductions reduce the gross rental income, leading to a net income or loss.

Common deductible expenses include mortgage interest paid on loans used to acquire or improve the rental property. Property taxes assessed by state and local governments are also fully deductible. Additionally, premiums paid for insurance policies covering the rental property, such as landlord liability or property damage insurance, can be deducted.

Costs associated with repairs and maintenance, such as fixing a leaky faucet or painting a unit, are generally deductible in the year they are paid. However, expenses for improvements that add to the value or prolong the life of the property, like a new roof or a significant renovation, must be depreciated over several years. Depreciation allows property owners to recover the cost of the building and certain improvements over their useful life.

Other deductible expenses encompass utilities paid by the landlord, advertising costs to find tenants, and professional fees for property management or legal services. These expenses collectively help in accurately calculating the net financial outcome of the rental activity for tax reporting.

Rules for Passive Activity Losses

The IRS imposes specific rules on how losses from passive activities, including most rental real estate, can be deducted. Under these Passive Activity Loss (PAL) rules, losses from passive activities can generally only be used to offset income from other passive activities. This means a passive loss cannot typically be used to reduce non-passive income, such as wages, salaries, or portfolio income like dividends and interest.

If a taxpayer’s passive losses exceed their passive income in a given tax year, the excess losses are not immediately deductible. Instead, these disallowed losses are referred to as “suspended losses.” These suspended losses are carried forward indefinitely to future tax years. They can then be used to offset passive income generated in those subsequent years.

When the taxpayer disposes of their entire interest in a passive activity in a fully taxable transaction, any remaining suspended losses associated with that activity can generally be deducted. This deduction can offset not only passive income but also non-passive income in the year of disposition, providing a potential tax benefit upon the sale of the rental property.

This limitation on passive losses aims to prevent taxpayers from using losses from certain investments to reduce their tax burden on active income.

Special Rules and Exceptions

While most rental activities are considered passive, the tax code provides certain exceptions that can alter how losses are treated. One significant exception applies to individuals who qualify as a real estate professional. To meet this status, a taxpayer must satisfy two primary criteria: more than half of the personal services performed in trades or businesses during the tax year must be performed in real property trades or businesses, and the taxpayer must perform more than 750 hours of services in real property trades or businesses in which they materially participate.

If a taxpayer qualifies as a real estate professional, their rental real estate activities are not automatically treated as passive activities. Instead, these activities are considered non-passive if the taxpayer materially participates in them. This allows real estate professionals to deduct losses from their rental activities against any type of income, including wages or business income, without the limitations of the passive activity loss rules.

Another exception, known as the active participation exception, allows some taxpayers to deduct a limited amount of passive rental losses against non-passive income. An individual is considered to actively participate if they make management decisions in a bona fide sense, such as approving tenants, setting rental terms, or approving expenditures. This does not require regular, continuous, and substantial involvement. Taxpayers who actively participate can deduct up to $25,000 of passive rental losses against non-passive income.

This $25,000 special allowance is subject to an Adjusted Gross Income (AGI) phase-out. The allowance begins to phase out for taxpayers with an AGI exceeding $100,000 and is fully phased out when AGI reaches $150,000. For every dollar of AGI above $100,000, the $25,000 special allowance is reduced by 50 cents.

Tax Reporting Requirements

Reporting passive rental income and expenses to the IRS involves specific forms. The primary form used for this purpose is Schedule E, Supplemental Income and Loss, which is attached to IRS Form 1040. On Schedule E, taxpayers report their gross rental income, along with all the deductible expenses, to calculate the net income or loss from their rental activities.

This form requires detailed breakdowns of various expense categories, such as advertising, cleaning and maintenance, insurance, management fees, mortgage interest, repairs, and taxes. Depreciation, a non-cash expense, is also calculated and reported on Schedule E. The net income or loss determined on Schedule E then flows directly to the taxpayer’s main Form 1040, affecting their overall taxable income.

If the rental activity results in a passive loss and the passive activity loss limitations apply, taxpayers must use IRS Form 8582, Passive Activity Loss Limitations. This form is used to calculate the amount of passive activity losses that can be deducted in the current tax year, taking into account any limitations. Form 8582 also tracks any suspended losses that are carried forward to future tax years.

The information from Schedule E, combined with any limitations calculated on Form 8582, ensures that rental income and losses are properly accounted for according to IRS regulations. These forms provide a structured way for taxpayers to report their rental real estate financial activities.