Is Real Estate Passive Income for Tax Purposes?

A common question arises regarding income generated from real estate activities, specifically whether it is considered “passive income.” The Internal Revenue Service (IRS) establishes specific criteria for determining whether an activity generates passive income, which directly impacts how taxpayers can utilize any associated losses. Properly classifying real estate income allows taxpayers to accurately report their earnings and deductions, ensuring compliance with federal tax regulations.

Understanding Passive Income for Tax Purposes

Passive income generally encompasses two main categories: income from trade or business activities in which the taxpayer does not materially participate, and all rental activities. Losses generated from passive activities can typically only be used to offset income from other passive activities.

These limitations are commonly known as the Passive Activity Loss (PAL) rules, which aim to prevent taxpayers from using losses from passive endeavors to reduce their taxable income from active sources. Conversely, active income is derived from services performed, such as wages, salaries, and income from a business in which the taxpayer materially participates. Portfolio income, another distinct category, includes earnings from investments like interest, dividends, annuities, and royalties, which are also generally not subject to passive activity loss limitations.

General Classification of Real Estate Income

Income derived from real estate activities is subject to specific classifications for tax purposes. Rental income, whether from residential or commercial properties, is typically presumed by the IRS to be a passive activity, regardless of the level of a taxpayer’s involvement. Any losses generated from these rental properties would fall under the passive activity loss limitations.

Other forms of real estate income, such as gains from the sale of property, can have varying classifications depending on the circumstances surrounding the transaction. If a property is held primarily for investment and sold, the gain is generally considered portfolio income, not passive income. However, if the property is part of a trade or business that involves active participation, the gain could be classified as active income. Similarly, income from real estate partnerships or limited liability companies (LLCs) can be classified as passive or active, depending on the taxpayer’s involvement in the entity’s operations and the specific nature of the income generated.

The Material Participation Test

Reclassifying an activity from passive to active, thereby allowing losses to offset active and portfolio income, hinges on meeting specific material participation tests. The Internal Revenue Service outlines seven such tests, and satisfying any one of them for a given trade or business activity can change its classification. One common test requires an individual to participate in the activity for more than 500 hours during the tax year.

Another test involves participation that constitutes substantially all of the participation in the activity by all individuals, including non-owners. This applies when a taxpayer is the primary individual involved in running the business. A third test, known as the significant participation activity (SPA) test, applies if the individual participates in the activity for more than 100 hours during the tax year, and their participation is significant when compared to other activities. If the sum of all SPAs exceeds 500 hours, they are considered to materially participate in each of them.

Furthermore, an activity qualifies if the individual participated in it for more than 100 hours during the tax year and no other individual participated for more hours. This test focuses on the relative level of involvement among participants. A fifth test considers whether the individual materially participated in the activity for any five of the ten preceding tax years, indicating a history of substantial involvement. For personal service activities, such as those in the fields of health, law, accounting, or consulting, a taxpayer materially participates if they materially participated in the activity for any three preceding tax years. The final test is a facts and circumstances determination, allowing for material participation if, based on all the facts and circumstances, the individual participated on a regular, continuous, and substantial basis during the year. This test often applies when none of the other quantitative tests are met but the taxpayer’s involvement is clearly significant.

Qualifying as a Real Estate Professional

Taxpayers engaged in real estate activities may qualify for a distinct and more favorable tax treatment if they meet the stringent criteria to be classified as a “real estate professional” (REP). This classification is particularly beneficial because it offers an exception to the general rule that all rental activities are automatically considered passive. To achieve REP status, a taxpayer must satisfy two primary tests related to their involvement in real property trades or businesses. These “real property trades or businesses” encompass various activities such as development, redevelopment, construction, acquisition, conversion, rental, operation, management, leasing, or brokerage of real property.

The first test requires that more than half of the personal services performed in all trades or businesses during the tax year by the taxpayer are performed in real property trades or businesses in which the taxpayer materially participates. The second, equally crucial test, mandates that the taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which they materially participate. Both of these quantitative thresholds must be met for a taxpayer to qualify as a real estate professional.

The significant tax advantage of qualifying as a real estate professional is that their rental real estate activities are not automatically treated as passive activities. Instead, if a qualified real estate professional materially participates in their rental real estate activities, any losses generated from these activities can be used to offset non-passive income, such as wages or business profits, without limitation. This provides a substantial benefit compared to the general passive activity loss rules, which typically restrict such loss utilization. For married couples filing jointly, one spouse must individually meet both of these tests to qualify for REP status, as the tests cannot be aggregated between spouses.

Tax Implications of Passive Real Estate Activities

The classification of real estate activities as passive carries specific tax implications, primarily governed by the Passive Activity Loss (PAL) rules. Under these rules, losses generated from passive activities can generally only be deducted against income from other passive activities. If a taxpayer’s passive losses exceed their passive income in a given tax year, the excess losses cannot be used to offset active or portfolio income. Instead, these unused losses are suspended, meaning they are carried forward indefinitely to future tax years.

These suspended losses can then be used to offset passive income generated in subsequent years. A significant opportunity to utilize suspended passive losses arises when a taxpayer disposes of their entire interest in a passive activity in a fully taxable transaction. Upon such a disposition, any previously suspended losses from that specific activity can be fully deducted against current year income, including active and portfolio income, to the extent they exceed any gain from the disposition. This allows taxpayers to eventually benefit from losses that were previously limited.

A special allowance exists for taxpayers who actively participate in rental real estate activities, even if they do not meet the stringent material participation tests. This “active participation exception” allows individuals to deduct up to $25,000 of losses from rental real estate activities against non-passive income. To qualify, the taxpayer must own at least 10% of the rental property and participate in management decisions, such as approving new tenants or deciding on rental terms. However, this $25,000 allowance is subject to an Adjusted Gross Income (AGI) phase-out. The allowance begins to phase out when a taxpayer’s AGI exceeds $100,000, and it is completely phased out for AGIs above $150,000. While passive income is generally taxable at ordinary income rates, its classification primarily dictates the deductibility of associated losses.