Is Rental Income Passive Income?

Real estate investors accounted for 28% of homes purchased in December 2023. One of the biggest draws to rental real estate is the potential for passive income streams. The idea of creating a cash flow without actively working at it is an opportunity few would pass up.

But the line between active and passive income can get blurry, especially when it comes to rental properties. Sure, you can collect rent checks without punching a time clock, but is rental income truly passive? What does it take to make it so?

This article covers the details of active versus passive income. We'll explore strategies to make your rental business more hands-off, the tax implications to consider, and how to calculate your net passive rental income. You'll gain an understanding of whether your rental business qualifies as passive income or if you need to rethink your level of involvement.

Active vs. passive income

Active income is what you earn from jobs where you take time out of your day to show up and put in effort. A salary from a day job or babysitting money are both examples of active income.

Passive income comes from activities that don't require your day-to-day involvement. This includes rental income, stock dividends, and book or music royalties.

Understanding rental income

Rental income is what you make from leasing out properties, whether it's a single-family home or a commercial real estate property. While it sounds straightforward enough, it’s not completely hands-off. There's work involved, such as:

• Preparing the property: Making sure the property is in good condition and meets local regulations for rental properties.
• Setting rent rates: Deciding on monthly rent prices based on the property’s location, size, and features.
• Finding tenants: Marketing the property to find potential tenants and screening them to confirm their reliability and ability to pay rent.
• Managing tenancies: Handling ongoing management tasks such as collecting rent, maintaining the property, and addressing tenant issues.

Is rental income passive or active?

Generally, the IRS considers rental income passive because rental property owners don't need to be actively involved in taking care of their property. However, this is determined on a case-by-case basis.

The IRS will assess your involvement in rental activities to determine whether your income is passive or active. They measure your property management against their passive activity and at-risk rules, focusing on material participation criteria such as how much time you've spent on your property. If you meet their criteria, your rental income could be labelled active due to your significant participation.

Strategies for maintaining passive rental income

To keep your real estate investments low maintenance and passive, here are a few strategies to consider:

Property management

Hiring a professional property manager can relieve you of the daily operational tasks associated with managing rental properties. These real estate professionals handle everything from advertising vacancies and conducting tenant screenings to managing lease agreements and renewals. They also take care of arranging routine maintenance as well as addressing emergency repairs, meaning that you don't have to be on-call 24/7.

Property management software

Using property management software can streamline many aspects of your daily operations so that you spend less time taking care of your rental property business. You can leverage software like Azibo to manage your rental properties in the following areas:

• Rent collection: Automate the rent collection process through online transactions. This eliminates the hassle of manual rent collection and reduces the risk of late or missing payments.
• Lease renewals: Streamline lease renewals through automatic reminders and digital contract management tools.
• Maintenance requests: Easily manage and track maintenance requests through a centralized platform where tenants can report issues.
• Tenant screening: Use Azibo to screen potential tenants with background checks, credit reports, and previous rental history.
• Financial tracking: Leverage comprehensive financial tracking capabilities. Track each rental property address and connect bank and mortgage accounts to monitor the income, expenses, and overall financial performance of your rental properties.

Reducing your taxable income

A benefit of real estate investing is being able to reduce your taxable passive income. Some of the ways you can do this include:

• Depreciation: One of real estate investors' most significant tax deductions is depreciation expense. It's not a true expense because there's no cash outlay, but it can reduce taxable net income and the overall taxes you pay.
• Mortgage interest deductions: Investors can deduct the interest paid on a rental property mortgage, which can often be a large portion of the early years' payments.
• Capital improvements: These capital expenses add value to the property, but you can't immediately deduct the full amount in the same tax year you incur them. Instead, you depreciate their cost over their expected life.
• 1031 exchange: A 1031 exchange allows investors to hold off on paying capital gains taxes on an investment property when they sell it as long as they buy another "like-kind" property with the profit gained from the sale.
• Pass-through deduction: As a rental property owner, you may be able to deduct up to 20% of income from pass-through businesses under the Tax Cuts and Jobs Act.
• Operating expenses: You can deduct all expenses related to running your property against your annual rental income. This includes costs like property management fees, advertising for new tenants, maintenance and repairs, and insurance premiums.
• Property tax deductions: Real estate property taxes are a deductible expense that can reduce your taxable income.
• Real estate professional status: You might qualify for this designation, which means you spend over 750 hours a year and more than half of your working time in real estate businesses. This status allows you to deduct all rental losses against your active income, providing a significant tax advantage.

Calculating passive real estate income

Let's break down how to calculate your income from rental activities. We'll use a single-family home purchased for $300,000 with a land value of $50,000 as an example.

Step 1: Add up rental income

Total all the money you received from rent and other income, such as application fees, late fees, and portions of security deposits retained due to property damage.

For our example property, the rental income is comprised of:

• Annual rent: $24,000
• Additional fees (from application and late fees): $500

Total rental income: $24,500

Step 2: Deduct operating expenses

Subtract all costs associated with running and maintaining the property. This includes expenses like advertising, property management fees, repairs, maintenance, insurance, and property taxes.

For our example property, the operating expenses include:

• Advertising: $500
• Property management fees: $1,500
• Repairs and maintenance: $3,000
• Insurance: $2,000
• Property taxes: $1,000

Total operating expenses: $8,000

Net income after expenses: Total rental income of $24,500 less total operating expenses of $8,000 = $16,500.

Step 3: Subtract mortgage interest

If you financed your property, you can deduct the interest portion of your mortgage payments. Note that the principal portion is not deductible since it's repayment of the loan.

For the single-family home example property, we have:

• Mortgage interest: $6,000
• Net income after expenses: $16,500

Net rental income: Total net income of $16,500 less mortgage interest of $6,000 = $10,500.

Step 4: Calculate depreciation

Calculate your rental property depreciation expense by taking the initial purchase price minus the land value, adding any closing costs and capital improvements, and then dividing by 27.5 years for residential property.

Let's say we have $20,000 in improvements. Our example property depreciation gets calculated as:

• Purchase price: $300,000
• Land value: $50,000
• Improvements: $20,000

Deprecation calculation: $300,000 - $50,000 + $20,000= $270,000

Annual depreciation expense: $270,000 / 27.5 = $9,818.18

Step 5: Determine taxable net income

Subtract the depreciation expense from your net operating income.

For our single-family home example, this looks like:

• Net rental income: $10,500
• Depreciation expense: $9,818.18

Taxable passive rental income: $10,500 - $9,818.18 = $681.82

Passive rental income takeaways

Earning truly passive rental income requires finding the right balance between hands-off investing and active management. While the IRS guidelines provide a framework, every real estate investor's situation is different.

Some investors may be comfortable taking a more passive approach by hiring property managers, while others prefer rolling up their sleeves for maximum control and potential upside.

Either way, understanding the tax implications and optimizing your strategy can make a big difference in your bottom line. The key is honestly evaluating your time, effort, and personal appetite for involvement to determine if your rental income dreams align with your reality.

Is rent passive income? FAQs

Is Airbnb income active or passive?

Airbnb income is passive unless you provide substantial services that go beyond typical rental activities, which might classify it as active.

Do you pay taxes on passive income?

Yes, you pay passive rental income tax. It's reported and taxed differently from active income, often at varying rates depending on the source.