Is Rental Income Considered Earned Income?

The classification of rental income is a frequent question for property owners. Understanding whether this income is considered earned or passive is important for tax compliance. The distinction dictates everything from payroll tax obligations to eligibility for certain tax benefits.

The General Rule for Rental Income

The Internal Revenue Service (IRS) classifies net income from rental real estate as passive income. This applies when the taxpayer is not actively involved in the rental activity on a regular and substantial basis. Passive income is generated from an enterprise where a person does not materially participate, unlike earned income, which includes wages, salaries, and profits from a business in which you actively work.

For most individuals who own a rental property alongside a full-time job, the income is passive. For example, an accountant who owns and rents out a single-family home collects passive income. This holds true even when performing landlord duties like screening tenants and arranging repairs, as these activities do not meet the IRS threshold for material participation.

Rental income includes more than monthly rent payments. It also encompasses advance rent, non-refundable pet fees, and any portion of a security deposit not returned to the tenant. If a tenant performs a service like painting in exchange for rent, the fair market value of that service is also rental income. This income is taxed at the taxpayer’s ordinary income tax rates.

Implications of Passive Income Classification

Classifying rental income as passive has financial consequences for federal employment taxes. Earned income is subject to Social Security and Medicare taxes under the Self-Employment Contributions Act (SECA), but passive rental income is not. Landlords do not pay the 15.3% self-employment tax on their net rental earnings.

Another implication involves retirement savings. Contributions to traditional and Roth Individual Retirement Arrangements (IRAs) are limited to a taxpayer’s earned income. Since rental income is passive, it cannot be used to fund these retirement accounts. A person whose only income is from rental properties would not be eligible to contribute to an IRA.

Passive rental income may also be subject to the Net Investment Income Tax (NIIT). This is a 3.8% tax on net investment income for taxpayers whose modified adjusted gross income (MAGI) exceeds certain thresholds. For 2024, these thresholds are $200,000 for single filers and $250,000 for those married filing jointly.

When Rental Income Can Be Earned Income

While the default classification is passive, rental income can be treated as earned income in specific circumstances. This reclassification happens when the rental activity rises to the level of a trade or business and the owner is significantly involved. The most direct path is qualifying as a “real estate professional” with the IRS, which requires meeting two annual tests.

The first test requires that more than half of the personal services you perform in all businesses during the year are in real property trades in which you materially participate. The second is performing more than 750 hours of services during the tax year in those same activities. Meeting these requirements can be difficult for someone with a full-time job outside of real estate.

Even without qualifying as a real estate professional, your rental income can be treated as non-passive if you “materially participate” in the activity. The IRS provides seven tests for this, such as working more than 500 hours on the activity during the year. Passing one of these tests can reclassify the rental activity as a business.

A final scenario involves providing substantial services to tenants, making the operation similar to a hotel. If services like regular cleaning or providing meals are included, the income is considered business income, not rental income, and is subject to self-employment taxes.

Tax Reporting for Rental Activities

The classification of your rental activity dictates which tax forms you use. For most landlords with passive income, rental income and expenses are reported on Schedule E (Form 1040). This form is used to list total rents received and subtract deductible expenses like mortgage interest, property taxes, and repairs.

If your rental activity qualifies as a trade or business, you will report income and expenses on Schedule C (Form 1040), Profit or Loss from Business. Income reported on Schedule C is earned income and the net profit is subject to self-employment taxes for Social Security and Medicare.

A related consideration is the Qualified Business Income (QBI) deduction under Section 199A of the tax code, which allows taxpayers to deduct up to 20% of their qualified business income. Rental real estate activities that rise to the level of a trade or business can be eligible for this deduction. This determination is separate from the material participation rules, and some activities reported on Schedule E may qualify.