Is Being a Landlord Passive Income for Taxes?
Understand the IRS's specific rules for classifying landlord income as passive and how it affects your tax liabilities.
Is Being a Landlord Passive Income for Taxes?
Many individuals commonly associate “passive income” with earnings that require minimal effort, such as rental income. However, the Internal Revenue Service (IRS) employs a distinct and technical definition for tax purposes. The IRS classification of an activity as passive or non-passive dictates how its associated income and losses are treated on a tax return. This distinction impacts landlords’ ability to deduct losses and manage their overall tax liability.
Defining Passive Activities for Tax Purposes
A “passive activity” under the Internal Revenue Code refers to any trade or business in which the taxpayer does not “materially participate” during the tax year. Material participation means regular, continuous, and substantial involvement. The IRS provides seven specific tests for material participation, such as participating for over 500 hours annually, or for over 100 hours and at least as much as any other individual. If a taxpayer meets any of these tests, the activity is generally non-passive. However, all rental activities are automatically considered passive, regardless of the owner’s material participation, unless an exception applies.
How Rental Activities Are Classified
Rental activities are generally classified as passive activities by default under tax law. This applies even when a landlord diligently manages properties, performing tasks like screening tenants, handling repairs, or collecting rent. The IRS primarily views income derived from the use of tangible property as passive.
However, limited exceptions exist where a rental activity may not be treated as passive. For instance, if the average period of customer use for a rental property is seven days or less, the activity might not be considered a rental activity under passive activity rules. This could allow it to be classified as an active trade or business if the taxpayer materially participates. Activities involving the provision of extraordinary personal services, such as hospitals or nursing homes, are also not considered rental activities. Another exception involves renting property to a C corporation in which the taxpayer materially participates.
Qualifying as a Real Estate Professional
The most significant exception to the rule that rental activities are passive involves qualifying as a “real estate professional” for tax purposes. To qualify, a taxpayer must satisfy two criteria. First, more than half of the personal services performed in all trades or businesses by the taxpayer during the tax year must be performed in real property trades or businesses in which the taxpayer materially participates. Second, the taxpayer must perform more than 750 hours of service during the tax year in real property trades or businesses in which they materially participate.
“Real property trades or businesses” include development, redevelopment, construction, acquisition, conversion, rental, operation, management, leasing, or brokerage of real property. If both criteria are met, the taxpayer’s rental real estate activities are no longer automatically treated as passive. Their classification then depends on whether the taxpayer materially participates in each specific rental activity, applying the general material participation tests. This status allows for greater flexibility in deducting losses.
Impact on Rental Income and Losses
The classification of rental income and losses has tax implications due to passive activity loss (PAL) limitations. Passive losses can only be deducted against passive income; they cannot offset non-passive income like wages or dividends. If passive losses exceed passive income, these excess losses are “suspended” and carried forward indefinitely to offset passive income in future tax years. Suspended losses can be fully deducted when the taxpayer disposes of their entire interest in the activity in a fully taxable transaction to an unrelated party.
For qualified real estate professionals whose rental activities are non-passive due to material participation, rental income and losses are treated as active. This means losses can generally offset any type of income, including wages or business profits, without the passive activity loss limitations. Non-real estate professionals who “actively participate” in rental real estate activities may deduct up to $25,000 of passive rental losses against non-passive income. This allowance begins to phase out when modified adjusted gross income (MAGI) exceeds $100,000, reducing by $1 for every $2 over this threshold, and is eliminated when MAGI reaches $150,000.