Summary: In this article, you’ll learn the difference between passive and active income. We will also answer the age-old question, is rental income passive or active? Comparing passive vs non passive rental income and the activities involved, is an important step for potential real estate investors.
For years, investors have used real estate as a way to build long-term wealth, earn extra monthly cash flow, and to take advantage of certain tax exemptions. Understanding how income is defined, as passive or active, is essential for real estate investors to ensure the greatest return on investment. This could be the difference between an investor earning positive monthly cash flow or negative.
Is rental income passive or active? Continue reading to find out. But first, let’s start with the basics…
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, (i.e. your job). 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 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 LLC’s 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 clearly illustrated from the lists above, anything an individual is actively participating 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 are receiving 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.
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.
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 into 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, may P2P companies have minimized such risks from occurring 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.
Dividend Stocks Explained
Investing in a dividend stock basically means you’re buying shares in a company. Dividend stocks are considered by many to be the most passive type of investment. Meaning, investing in dividend-paying stocks requires money, with little to no time or energy requirement.
Most companies pay dividends to investors every quarter or three months. For example, imagine investing $75,000 into a company that pays 6% a year in dividends. 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 standpoint.
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 loss 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.
Before we get too deep into the intricacies of how income is taxed, if you’d like to know more, check out my recent 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 (literally) pay off.
Pay special attention to markets that are experiencing population growth, job growth and appreciation potential. For more information, check out some of the top real estate markets 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’re spending 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, is rental income 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.