For years, real estate has been a trusted path for investors to build long-term wealth, offering the potential for extra monthly cash flow and the advantage of certain tax exemptions. If you’re newer to real estate investing, you might be asking yourself, is rental income passive or active? Understanding this distinction is not only important; it is the key to maximizing your return on investment (ROI), and it could be the difference between earning positive monthly cash flow or negative.
Below, we’ll cover everything you need to know, including what active and passive income are, methods for growing your passive income and answer the age-old question: is rental income passive or active?
What is Active Income?
In order to understand if rental income is passive or active, you must first know what active income really means. Also described as non-passive income, active income is money earned from work that you do, like a 9 to 5 job or a side hustle. According to the IRS, “non-passive activities are businesses in which the taxpayer works on a regular, continuous, and substantial basis.”
Active / Non-Passive Activities
Whether you’re making money or losing money, the following are typically considered active income or non-passive activities:
- Salaries, wages, and commission income
- Guaranteed payments
- Interest and dividends
- Stocks and bonds
- Sale of undeveloped land or investment property
- Royalties from ordinary business
- Sole proprietorship or farm where the individual materially participates
- Partnerships, S-Corporations, and LLCs where the individual materially participates
- Trusts where the individual materially participates
Defining “Material Participation”
As outlined by the IRS, the standards for material participation include:
- 500+ hours toward a business or activity from which you are profiting
- If participation has been “substantially all” of the participation for that tax year
- Up to 100 hours of participation and at least as much as any other person involved in the activity
As the lists above clearly illustrate, anything an individual actively participates in is considered active or non-passive income and is taxed as such. More on that later.
What is Passive Income?
Passive income is any money made from your investments. The IRS describes passive activity as “any rental activity OR any business in which the taxpayer does not materially participate.”
For example, let’s say you invest $100,000 in a bicycle shop and receive a percentage of earnings from the owners each month. As long as you aren’t participating in the operation of the bike shop in a meaningful way, this would be considered passive income.
Two Types of Passive Activities
- Rentals. This includes equipment and real estate.
- Businesses. Where the individual does not materially participate on a regular, continuous and substantial basis.
Passive Activities
The following are considered passive activities:
- Equipment leasing
- Rental real estate (some exceptions apply)
- Sole proprietorship or farm where the individual does not materially participate
- Limited partnerships
- Partnerships, S-Corporations, and LLCs where the individual does not materially participate
Popular Types of Passive Income
The most popular types of passive income include real estate, peer-to-peer (P2P) lending and dividend stocks. Let’s talk about the last two before we move into passive rental income.
1. Peer-to-Peer (P2P) Lending Explained
Peer-to-peer lending is basically exactly how it sounds. More and more individuals looking to earn passive income have started investing their money in P2P lending companies. These companies then turn around and lend your money (along with other investors’ money) to peers.
Also known as lending clubs, your money is used in the form of personal loans, and investors earn money on interest, just as banks or other lenders would. The ROI on these types of investments can vary, but on average, it’s between 5% and 10%.
As with any investment, there is risk involved in P2P lending in the event of someone defaulting on a loan. In other words, if a borrower stops making regular payments on their loan, this could affect potential ROI. However, P2P companies may have minimized such risks by enforcing strict underwriting standards.
Do your research before investing in a P2P lending company to ensure your money is subject to as little risk as possible.
2. Dividend Stocks Explained
Investing in dividend stocks involves purchasing shares in a company that pays regular dividends to its shareholders. Many people view dividend stocks as a passive investment option because, beyond the initial purchase, minimal time and effort are needed to continue earning dividend income.
Companies pay dividends to investors either monthly, quarterly or annually. For example, if you invested $75,000 into a company that pays 6% a year in dividends and issues dividends every three months (quarterly). You would then receive a check every three months for $1,125 without doing much of anything.
On top of the regular cash payment, dividend investors can earn money from the stock appreciating or increasing in value. The most appealing part of this type of investment is that passive income is earned in the form of consistent cash flow without having to deal with managing the investment.
Passive Income Benefits
There are many benefits to passive income, which will be discussed in more detail in the next section. One of the most appealing benefits comes from a taxpayer’s standpoint—tax deductions.
For instance, if an investor reports a loss on passive income or activity, certain expenses may be tax deductible. Thus, making sure your investments qualify as passive allows investors to offset any or all losses through tax deductions.
Whereas non-passive income is taxed completely differently. A loss from passive activity may not be used to offset non-passive income.
If you’d like to know more about landlord deductions, check out my article, Top 18 Landlord Tax Deductions to Maximize Your Profit.
Is Rental Income Passive or Active?
And finally, the answer you’ve been waiting for: Is rental income passive or active?
Rental income is any money received for the use of a tangible property. As mentioned previously, rental income is one of the most popular ways for investors to earn passive income.
All rental activities are generally considered passive income. Investing in real estate is considered passive income because you’re generating revenue from money you’ve already invested in the property. Even if you’re materially participating as a landlord to your investment properties, it’s still considered passive income.
In fact, more and more people are taking some or all of their money out of the stock market and buying rental properties. As with any investment, there is a risk of losing money. However, spending a little extra time analyzing strong real estate markets in different parts of the country has proven to pay off (literally).
Pay special attention to markets experiencing:
- Population growth
- Job growth
- Appreciation potential
If you want to know some of the markets RealWealth recommends, check out some of the top real estate markets for investors in the country.
Passive vs. Non-Passive Rental Income
Let’s say you own several rental properties and spend 50 hours a month managing, maintaining and finding tenants for your properties. The rental income from these properties is still considered passive, even though you spend 500+ hours a year on its operation.
There are only two scenarios in which rental income would be considered active. The first is if your job is working as a real estate professional. The second is if you are renting your property to a company or partnership where you conduct business.
A real estate professional is considered non-passive if the following three requirements of material participation are met:
- 50% of services are performed in real property trades or businesses over the duration of a year.
- 750+ hours of service in real property business
- Participates materially in real estate activity
With these material participation requirements in mind, investors can clearly distinguish between passive and non-passive rental income.
Answering the question of whether rental income is passive or active is one of the first steps to becoming a savvy investor. It’s easy to see why so many people choose to earn extra monthly cash flow through passive rental investments. Making your hard-earned money work for you can set you up for early retirement, long-term wealth, tax advantages and more.
How RealWealth Can Help You Create Passive Rental Income
Earning rental income can bring huge benefits to your life, giving you more financial freedom and stability. At RealWealth®, we help investors build a passive real estate portfolio so they can live life on their own terms. We do this by connecting them with vetted property teams that sell professionally managed turnkey properties in the top markets nationwide. It’s free to join RealWealth, and membership gives you full access to all of our educational resources, property providers and network of recommended lenders, CPAs, 1031 exchange facilitators, and more. If you are looking to create passive rental income, join RealWealth today!
