It Matters Whether Real Estate Income Active or Passive

June 8, 2023

Why does it matter?

Whether your activity in rental real estate is active or passive matters for what taxes you pay and what income can be offset with losses.

Passive income is not subject to payroll taxes (Medicare and Social Security) and, therefore, does not count towards your social security retirement benefit. All else equal, not paying into social security makes your future retirement benefit smaller. If you have losses in a passive activity, it can only offset other passive income (subject also to “at risk rules”) and any excess losses are carried forward to future years.

The opposite is true for active income but still subject to at risk rules.

The IRS allows an exception to the passive loss rules for taxpayers who “actively participate” in rental real estate activities to deduct up to $25,000 in rental real estate losses against their active income if their modified adjusted gross income is below $100,000 married filing jointly (50% deduction when MAGI is below $150,000).[1]

What is Actively Participate?

To actively participate means to make management decisions such as:

• Approving new tenants
• Deciding on rental terms
• Approving expenditures[2]

Active participation is less stringent than “material participation” that is required to make income active.

So, What Counts as Material Participation?

Generally, rental activities are passive activities even if you materially participated in them. However, if you qualify as a “real estate professional,” rental real estate activities in which you materially participated are active activities.[3] .

You qualify as a real estate professional if you meet both of the following requirements:

• More than half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.
• You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.

You cannot count personal services performed as an employee in a real property trade or business unless you were a 5% (or higher) owner.

What to Take Away?

The Social Security retirement benefit is often an important part of retirement income. It’s important to know what decisions made today impact the future.

Real estate often requires large investments that have the potential to put a property into a loss. It’s important to know what the loss can offset for other income in that year for proper tax planning.

It's worth noting that tax laws and regulations can change over time, so it's essential to consult with a qualified tax professional or accountant who can provide up-to-date information and guidance on the specific tax implications of real estate investments. They can help navigate the complex tax landscape, optimize deductions, and ensure compliance with applicable tax laws, maximizing the tax benefits and minimizing any potential tax liabilities associated with real estate investments.