Is Rental Income Considered Investment Income?

The tax classification for income from a rental property depends on the owner’s level of involvement. How this income is categorized by the Internal Revenue Service (IRS) influences which taxes apply and how the income is reported. This classification dictates whether the earnings are simply rental income or if they fall into a category subject to additional taxes.

Classifying Your Rental Activities

The IRS considers rental real estate activities to be “passive activities” by default, regardless of the owner’s material participation. This status means the income is subject to a specific set of rules. However, certain exceptions can change this classification, moving the income from passive to non-passive.

One way to reclassify rental income as non-passive is by qualifying as a “real estate professional.” This status requires meeting two IRS tests annually. First, more than half of the total personal services you perform during the year must be in real property trades or businesses. Second, you must spend more than 750 hours of service in those same real property trades or businesses.

Real property trades or businesses include activities like development, construction, acquisition, conversion, rental, management, or brokerage. Spouses cannot combine their hours to meet the 750-hour test; one spouse must qualify on their own. Meeting these requirements allows a taxpayer to treat their rental activities as non-passive.

A rental activity may also be treated as a non-passive trade or business if the owner provides substantial services. This can occur when services similar to a hotel or bed and breakfast are offered, such as regular cleaning or changing linens. Providing these types of personal services can elevate the activity to a business.

Understanding Net Investment Income

Net Investment Income (NII) is the basis for a 3.8% tax that applies to some taxpayers. NII includes income sources not derived from an active trade or business. Common categories of NII include:

• Interest
• Dividends
• Capital gains
• Annuities
• Royalties

Net income from passive activities is included in NII, which directly connects your rental property’s classification to this tax. If your rental activity is passive, its net income is part of the NII calculation. Therefore, the distinction between a passive and non-passive rental activity is significant.

The Net Investment Income Tax (NIIT) is triggered if a taxpayer’s Modified Adjusted Gross Income (MAGI) exceeds certain thresholds. The threshold is $200,000 for single or head of household filers, $250,000 for married filing jointly, and $125,000 for married filing separately. These income thresholds are fixed and not adjusted for inflation.

Calculating the Net Investment Income Tax on Rental Income

If your rental activity is passive and your MAGI surpasses the applicable threshold, the net income from that rental is subject to the 3.8% NIIT. The tax is calculated on the lesser of your total NII or the amount by which your MAGI exceeds the threshold, and is reported on Form 8960. To determine the net rental income, you subtract all ordinary and necessary rental expenses from your gross rental income.

Allowable rental expenses include:

• Mortgage interest
• Property taxes
• Insurance
• Maintenance and repairs
• Depreciation

For example, a single individual with a MAGI of $220,000 has a passive rental activity. If the property generates $20,000 in gross rent and has $12,000 in expenses, the net rental income is $8,000. This $8,000 is included in their NII and is subject to the 3.8% tax.

If a taxpayer qualifies as a real estate professional and materially participates in the rental activity, the income is non-passive. Because the activity is not passive, the net rental income is not included in NII. Therefore, it is not subject to the 3.8% NIIT, even if the taxpayer’s MAGI is above the threshold.

A safe harbor provision exists for real estate professionals. If a qualifying real estate professional spends more than 500 hours on their rental activities during the year, the income is exempt from the NIIT. The gain from the sale of a rental property may also be subject to the NIIT if the activity was passive.

Special Considerations for Rental Income

Self-rental income has unique rules. This occurs when you rent property to a trade or business in which you materially participate. In this situation, the net rental income is recharacterized as non-passive and is not subject to the NIIT.

Income from renting raw land, or a ground lease, is considered passive income. As passive income, it is included in NII. If the property owner’s MAGI exceeds the NIIT thresholds, this income is subject to the 3.8% tax.

For properties with mixed personal and rental use, like vacation homes, expenses must be allocated between the two uses. Only the net income from the rental portion is considered for the NIIT calculation. If you rent a dwelling unit that you also use as a home for fewer than 15 days during the year, you do not report any of the rental income.