Real Estate Tax Rules: Understanding Passive vs. Active Income

Investing in real estate can be a great way to build wealth, but knowing the associated tax rules allows you to make the most of your investments. While many property owners hope for substantial tax breaks, the IRS classifies rental income as either “passive” or “active,” which can impact the deductions you qualify for. Passive activities typically involve limited hands-on engagement, while active ones require greater participation. Knowing where your activities fall can help you optimize your returns.

Passive Activity: Understanding the Limits

Rental properties with minimal involvement are typically classified as passive activities, which restrict tax deductions since passive losses can only offset passive income. Excess losses become “suspended losses” that carry forward to future years. Properties managed by a property manager often fall under this classification; however, if you own at least 10% of the property and are involved in significant management decisions, the activity may qualify as active.

Disclaimer: Consult your tax adviser for further guidance regarding your circumstances.

Let’s assume you own a rental property. In Year 1, you made $15,000 gross income and had $20,000 in expenses. In Year 2, you made $15,000 gross income and had $10,000 in expenses. Here is what your tax situation would look like if you were passive vs. active.

Rental Example	Passive	Active	Comments
Year 1:
Income	$15,000	$15,000
(Deductions)	(20,000)	(20,000)
Net Income/(Loss)	($5,000)	($5,000)	Whether you were passive or active in this one rental, you would have a loss of $5,000. Now consider the tax treatment:
Tax Return (Loss)	$0	($5,000)	If you are passive, you will not be able to deduct any of these losses. These losses would be remembered (or “suspended”) to be deducted in a future tax year. However, if you meet one of the material participation tests that make you Active, you can deduct these.
Tax Return Losses Suspended	($5,000)	$0

Year 2:
Income	$15,000	$15,000
(Deductions)	(10,000)	(10,000)
Net Income/(Loss)	$5,000	$5,000	Whether you were passive or active in this one rental, you would have $5,000 of income to pay tax on.
Consider: Tax Suspended Loss from the Prior Year	+(5,000)	+$0	However, remember that you might have some passive losses carried forward from last year!
Total Tax Return Income	$0	$5,000	You would pay income tax on this income.

Active Activity: Getting Extra Tax Perks

To qualify for active status and access additional tax benefits, you must meet the IRS’s material participation criteria by satisfying at least one of seven specific tests. The most common tests include:

500-Hour Test: Spending over 500 hours on a single activity, such as managing one property or business.
Sole Participant Test: Being the only individual managing the property.
100-Hour and Most Involved Test: Spending 100+ hours working on the property and working more than anyone else involved with the property.
Significant Participation Test: Spending 100+ hours on multiple passive activities, with a combined total of at least 500 hours across all activities.
Prior-Year Test: Being actively involved in the property for five of the last 10 years.
Personal Service Activity Test: Spending at least three years working in certain personal service activities, such as health, law, or consulting, and applying that expertise in managing the property.
Facts and Circumstances Test: Demonstrating substantial involvement, typically 100+ hours, with a focus on the importance and impact of your role, such as making key decisions or managing critical operations.

Real Estate Professional Status and Short-Term Rentals

If you’re heavily involved in real estate, you might qualify for Real Estate Professional Tax Status (REPS), an IRS-recognized designation for individuals extensively engaged in real property trades or businesses. By dedicating at least 750 hours per year to real estate activities and making it your primary occupation, you could unlock greater deductions by offsetting other sources of income. Short-term rentals, like Airbnb properties, may also avoid passive limits if you’re materially involved. This distinction is critical since short-term rentals aren’t automatically passive and could allow for more deductions if actively managed.

The 199A Deduction

Section 199A, or the Qualified Business Income (QBI) deduction, lets some taxpayers deduct up to 20% of qualified business income. Real estate investors could benefit if their rental qualifies as a business, but this often requires active involvement. Our advisors can help determine your eligibility and guide you through the details.

Note: Pending Congress’ actions in the next year, this deduction could be extended or expire.

Deductible Expenses, Including Lease Acquisition

Lease acquisition costs and commissions are typically capitalized and depreciated over time, regardless of whether your rental activity is considered passive or active. In general, both passive and active rental activities can deduct the same types of expenses. However, being actively involved in the rental may allow you to deduct more each year due to higher limits on losses or deductions. Handling these costs wisely can save you on taxes over the long term, and having a solid plan for capital expenses can help support your financial goals.

IRS Publication 527 and Keeping Good Records

IRS Publication 527 is an excellent resource for rental property tax rules, covering topics such as income, deductible expenses, and depreciation. Keeping detailed records of your hours, maintenance, and costs is essential for proving active status and tracking significant improvements. These improvements add to the property’s basis and might help reduce capital gains tax if you sell.

Final Thoughts

Real estate tax rules can be complex. Many investors anticipate large deductions when investing in real estate, but IRS guidelines often limit what can be written off. Get guidance for participation tests, rules for qualifying for REPS, and qualifications for 199A deductions. With our help, you can maximize your tax benefits and align your strategy with your financial goals. Contact Grimbleby Coleman to get started today.