Rental Income: Active or Passive
Tax law specifies that all rental activities are passive activities, even if the landlord is a material participant, unless the taxpayer is a qualified real estate professional or the rental businesses are classified as active businesses by the tax code. Hence, losses from rentals can only be deducted from other passive income. Rental income is any income received for the use of tangible, either real or personal, property. The tax code provides material participation rules that distinguishes active from passive activity. If at least 1 of the material participation rules is satisfied, then rental income can be classified as active income only if it satisfies one of the following exceptions; otherwise it must be classified as passive income even if the taxpayer is a material participant. However, there is an exception for deducting up to $25,000 of rental losses against active or portfolio income if active participation tests are satisfied, even if the material participation tests are not. However, the $25,000 rental loss allowance phases out for taxpayers with incomes exceeding $100,000, phasing out completely at $150,000.
Example: So if you own a number of homes that you rent out to the public, and spend 60 hours a month in the business, it will still be classified as a passive activity even though you spend more than 500 hours a year in its operation unless you satisfy one of the following exceptions.
Exception 1. The average rental period is 7 days or less. This exception is provided because there is a presumption that for short-term rentals, such as for the rental of intangible property like automobiles, tools, or other property, the taxpayer must expend considerably more effort to service the business then would be required for long-term rentals.
If a taxpayer rents a vacation unit for 7 days or less, any losses are treated as active losses that can be deducted from active income if the taxpayer meets the material participation test. In any case, it does not qualify for the $25,000 rental loss allowance since it is not treated as a rental property.
Exception 2. The use of the property averages 30 days or less, and the owner provides significant personal services. For this exception to apply, the taxpayer must show that he provided significant services. Proof consists of the frequency of services provided, the amount and type of labor that is required for the activity, and the value of the services to the amount charged for the use of the property.
Personal services do not include services that are required:
- for lawful uses of the property;
- for construction or repair services that extend the useful life of the property; or
- for services that are provided for long-term maintenance of high-grade commercial or residential real property, such as cleaning and maintenance, trash collection, and the provision of security.
For Exceptions 1 and 2, if more than 1 class of property is rented out, then the rental period is averaged within each class.
Average Period = Gross Rental Income from That Class / Total Rental Income from the Activity
Exception 3. The main purpose of the business is to render personal services, so the rental of the property is incidental to the main business. For instance, for a college that rents out dormitories, the dormitories are incidental to the service of providing education. Likewise, a hospital room rental is incidental to the provision of health services. With this exception, the rental period is immaterial.
Exception 4. The rental business is incidental to the main activity of the taxpayer. This exception was written to prevent the conversion of active or portfolio income into passive income so that passive losses can be deducted from it. The tax code specifies that the following types of rentals are not passive activities:
- If gross rent income is less than 2% of the lesser of the unadjusted basis or the fair market value of the property, then this exception is satisfied for:
- Property held primarily for investment.
- Property that was used by the taxpayer in a trade or business either during the tax year or during at least 2 of the 5 preceding tax years.
- This exception also applies to the following property rentals:
- Property held for sale to the general public but rented in the meantime. So if a car dealer rents out used cars until they are sold, then this exception applies.
- Property rentals by a partner to a partnership.
- An employer renting lodging to an employee so that the employee can perform services for the employer.
Example: If you own raw land with a fair market value of $300,000 and has an unadjusted basis of $200,000, and you rent the land to a farmer for $3,000, then the land rental is not considered a passive activity, since $3,000 < .02 × $200,000.
Exception 5. The property is available during defined business hours for nonexclusive use by customers, such as public golf courses, even if they provide monthly or annual passes to some of its customers. Partnerships or S corporations can only qualify for Exception 5 if their primary activity is not rentals.
Exception 6. If a taxpayer rents property to a partnership, S corporation, or joint venture in which the taxpayer owns an interest, then the customers are treated as licensees rather than lessees.
For the above listed exceptions, the $25,000 real estate rental loss allowance does not apply.
The rental of a personal residence is considered a nonpassive rental activity if the taxpayer uses the home for more than the greater of 14 days or 10% of the days that the home is rented out for a fair market rental value.
Rental and Non-Rental Business Activities Cannot Be Combined
Activities involving the rental of real property and personal property cannot be combined into a single activity unless there is a natural connection between the 2. For instance, if you rent a furnished apartment, then the activity can be considered a single activity even though you are renting both realty and personal property.
Rental and non-rental business activities may be combined if they make an appropriate economic unit and one of the activities is considered insubstantial to the other, or if the business owners have a proportionate ownership in both the rental activity and the non-rental business and the businesses form a natural combination.
Real Estate Professionals Can Treat Rental Income as Active Income
Real estate professionals can treat their rental income as active income rather than passive income, thus allowing losses from the rental activity to offset any other income. The tax code defines real estate professional as (1) one in which more than 50% of the personal services performed by the taxpayer were in the real estate business, which can involve real property development or construction, acquisition, conversion, operation, management, rental or leasing, or a brokerage business — but not real estate financing — and (2) the taxpayer performed more than 750 hours of service in each activity, defined as a separate business or property, but since the activities can be aggregated, the each activity requirement is not much of a restriction. If a married couple is engaged in the activity, then at least 1 of the spouses must satisfy both of the above tests. A real estate professional cannot be an employee unless she owns more than a 5% interest in the employer. However, the real estate professional rules do not apply to real estate rentals that are combined with another business activity. A closely held C corporation can qualify under the rules if at least 50% of its receipts are from the real estate business in which it materially participates.
Each activity in a rental interest is treated as a separate activity unless the taxpayer elects to aggregate them on Schedule E, Supplemental Income and Loss. If the activities are not aggregated, then the taxpayer would have to satisfy the above 2 rules for each property. However, the rental loss allowance can still be used for any properties for which the taxpayer does not qualify as a real estate professional, so up to $25,000 of losses from those properties can be combined with any losses from the other properties to offset nonpassive income.
If the taxpayer makes the election to aggregate the activities, then it cannot be changed in subsequent years unless there is a material change in the nature of the activity or permission is granted by the IRS, even if there are intervening years in which the taxpayer would not qualify as a real estate professional. Another disadvantage is that suspended losses cannot be applied to the sale of any rental properties until the entire interest is disposed of.
Generally, a real estate interest held by a partnership or S corporation is treated as an aggregate interest if the business entity treats it as such; otherwise, the real estate interests are treated as separate for the investor, which will also be the case if the taxpayer holds at least a 50% interest in the capital, income, gain, loss, deduction, or credit in a partnership or S corporation for the tax year, unless the taxpayer elects to aggregate all the real estate interests held individually and as an interest in the business entity. If the interest is held as a limited partnership interest, then the limited partner must satisfy Rules 1, 5, or 6 of the material participation tests — specifically, did the limited partner actively participate for at least 500 hours during the tax year or did he actively participate in the same activity in previous years — to satisfy the material participation rules, which will also apply if the taxpayer decides to aggregate the limited partner interest with other real estate interests. However, there is a de minimis exception that allows a taxpayer to aggregate all of the real estate rental activities by satisfying any 1 of the 7 material participation tests if less than 10% of the gross rental income for the tax year is attributed to the limited partnership interest.