Active Income, Passive Income – What's the Difference?

Real estate can be a profitable undertaking. There are various ways to make money. Sometimes it comes in large chunks, and sometimes it comes in regular intervals. Every time though, there is a tax man (or woman) ready to take their portion – whether it is a fair amount or not is open to discussion. There is an old saying that we will consider today, “it's not how much you make, it's how much you keep”.

Since everyone's situation is different, the purpose of this is to help you ask intelligent questions of your tax advisor and plan your business to minimize the April 15 impact. There are carve outs and phaseouts inserted into the tax code at various times with only a tangential nod to uniformity and common sense, so it's as the say. “the devil is in the details”.

I don't make the rules, and the people who made up some of these rules are probably long gone. You will see the term “generally” used quite often in this discussion and that is because the tax code was never designed to be a unified, logical exercise. Each piece came in individually, generated by a committee that was subject to various influences and compromises.

Not All Income Is Equal

Most investors are aware of the fact that long term capital gain is taxed at a lower rate than regular income. But there is more to it than that. While old timers are probably well aware of this, many newcomers are not. In many cases, rental income is taxed differently than fix and flip income. Knowing how the tax code is structured is the first step toward minimizing your “contributions” to the Washington leviathan.

Two Types of Income

There is regular income – the kind you work for. It can be for an employer who gives you a W-2 at the end of the year. It can be from self-employment where you file a Schedule C. It can be from your interest in an LLC or S Corp where the tax liability passes through the business down to the individual owners tax return by way of a K1. These are all taxed at the individual rates, designed to extract the maximum number of dollars from the working taxpayer. There are some exceptions that we will discuss later.

Then there is passive income. Yes, you may have to do some work to get this, but generally your involvement is not as great, and, ironically, you don't pay as much tax on this “mailbox money” income.

Passive Income

We will take a look at passive income first. It is the dream of many to spend their afternoons lounging in a hammock while money rolls in the front door. When you have rental property, this is how the IRS sees you, even though you “materially participate” in the operation of your empire.

That is, they regard pretty much all rental activity as passive even though you take part in deciding rental terms, approving tenants, and making repairs, whether you hire someone or do some yourself.

The same is true if you are an investor in a rehab project and someone else takes care of the work – acting as the general contractor or doing much of the work themselves. Just do not become too involved in the day to day activities. You might say, “couldn't I just lend them the money?” The answer would be no, not if you want the income to be passive. Interest income is generally taxed as regular income.

Truth be told, passive income has the same tax rate as regular income – but – and it's a big one – unlike self employment or regular business income there is no self employment tax. That is a 15.3% savings. That's not 15.3% off your tax bill, that is 15.3% of your profit that you get to keep. Some will say by not paying that you are not putting money away for your retirement. If this bothers you, perhaps passive income isn't for you, but if you think you can do better than the social security people... go for it!

The Caveats

Passive losses generally can only offset passive income, although, under some circumstances, if you qualify, up to $25,000 can be applied to regular income. You can qualify by being actively involved in the business and have at least 10% ownership in the properties. Even that phases out at $150,000 if you are filing a joint return... less if you are single.

On the other hand, if you are considered to be a real estate professional, rental income is no different from any other.

What is a Professional

If you are seriously in the real estate business it is easy to fall into the professional classification. If you spend more than 750 hours in a year in the trades or materially participating in the business or more than half your personal service time in such activity you lose your amateur status.

Qualifying Business Income Deduction

Real estate professionals generally benefit from the Qualifying Business Income deduction, otherwise knows as QBI. With this, you can knock up to 20% of your business profit off your Adjusted Gross Income (AGI). There again, there are limitations you tax advisor can explain in greater detail. You may not benefit from this much in the future unless sanity remains in Washington.

And there is good news for rental owners here too. If they treat it as a serious business, keeping separate records for each property. This includes contemporaneous records of time spent and activities performed in the various aspects of the rental business.

Keep What You Can

Volumes have been written and people have spent years learning the ins and outs of the tax code. This article is just something to get you thinking about the impact of taxes on your financial well being. We have not touched on the benefits of operating through a self-directed IRA. It could be well worth the time of both the serious and casual real estate investors to get to know more about the tax environment. It won't make you more money, but it could save you a boat load if you do it right... but push yourself beyond the law... the IRS can do bad things to people who chisel when they file.