Is rental income passive or active? Why it matters (2024)

Real estate investing and the rental income generated are classified by the Internal Revenue Service (IRS) as either active income or passive income. It’s an essential distinction because the classification of activity and rental income significantly impact the amount of taxes an investor must pay and when.

We’ll explain the difference between passive and active rental income, how to calculate rental income, and exceptions to the passive rental income rule.

Key takeaways

  • Active real estate investing generates income by developing homes or fixing and flipping, while income generated from buy-and-hold investments is considered passive income.
  • Although the word “passive” is often used to describe real estate investing and rental income, few investments are truly entirely passive.
  • In most cases, rental income is treated as passive income, even when an investor spends time overseeing a rental property business.

Passive vs. active rental income

In the real estate business, active investing includes real estate developing, wholesaling, and fixing and flipping. Generally speaking, active investing occurs when an investor works on their business full time regularly and continuously.

On the other hand, real estate investors can earn passive rental income by owning shares of a real estate investment trust (REIT), participating as a silent partner in a real estate syndication or limited liability company (LLC), or buying and holding rental property. Passive real estate investing is often thought of as a “side gig” versus having a full-time job.

Is rental income passive or active?

One of the confusing things about active versus passive rental income is that few real estate investments—or any other investment, for that matter—are truly passive; at some point, there is usually material participation on the part of the investor. Take owning an out-of-state rental property, for example.

There is a lot of active participation, even for remote real estate investors who frequently choose to turn the day-to-day details over to a local property manager rather than managing the property from a distance. Typical property management tasks include marketing a vacant property, finding and screening tenants, collecting the rent and taking care of tenant communications, managing repairs and maintenance, and providing regular reports to the owner.

But even though many of the rental real estate activities of owning a rental property remotely are delegated to a third party, there is still a certain amount of work an investor has to do. Reviewing financial statements, periodically speaking with the property manager, making decisions on capital repairs or renovations, and visiting the rental property once or twice a year are examples of the things that remote real estate investors do.

All of those tasks sound more active than passive.

However, according to IRS Publication 925, a rental activity is passive even if an investor materially participates in the activity. The IRS considers a rental activity to be passive if real estate is used by tenants and rental income (or expected rental income) is received mainly for the use of the property.

In other words, owning a rental property and collecting rental income is considered passive and not active in most cases. However, there are exceptions to this rule investors should be aware of.

Exceptions to the passive rental income rule

While rental income is almost always considered to be passive, there are a few possible exceptions to the rule. The IRS may treat income from rental property as active if:

  • The rental property owner is classified as a real estate professional. A real estate professional is someone who works a minimum of 750 hours per calendar year in the real estate profession and with at least 50% of their work being in real estate.
  • Property is rented to a company, such as an LLC or S corporation, in which the investor holds an interest.
  • Rental income from short-term rentals (STRs) may be considered active if the average period of a tenant’s stay is 7 days or fewer.
  • Rental income from a personal residence may be active if the home is occupied as a personal residence for more than 14 days or 10% of the days the home is rented out.

There are additional guidelines to determine if rental income is passive or active. Investors may wish to consult with their financial professional or tax advisor to better understand how the rules apply in their specific situation.

Is rental income passive or active? Why it matters (1)

How passive rental income is taxed

Taxes must be paid on rental income, whether the income is active or passive, but taxes work in different ways. An investor who receives active rental income must generally pay payroll taxes, such as Social Security, Medicare, and federal and state unemployment taxes because the income is generated from work done. On the other hand, passive income comes from money that was invested, similar to receiving a stock dividend.

Here are the general steps to follow to calculate taxable passive rental income:

  1. Calculate all rental income received. Rent income may include normal monthly rent payments, applications, late fees, and any amount of a tenant’s refundable security deposit not returned to the tenant (such as for damage beyond normal wear and tear.)
  2. Subtract operating expenses from total income received. Operating expenses typically found in a rental property include advertising and marketing fees, leasing commissions, property management fees, repairs and maintenance, landscaping, pest control, landlord insurance, homeowner association (HOA) fees, property taxes, and professional service fees paid to a real estate attorney or certified public accountant (CPA).
  3. Subtract mortgage interest if the property is financed. The principal portion of the mortgage payment is not deducted because those funds are used to pay down the mortgage liability on the real estate balance sheet.
  4. Subtract operating expenses and mortgage interest from total rental income received to determine net income before depreciation expense.
  5. Calculate annual depreciation expense by dividing the property basis by 27.5 years for residential income property. Property basis includes the price paid for the property, less the value of the lot or land, plus closing costs, such as title insurance and recording fees. Capital repairs, such as installing a new roof or heating, ventilation, and air conditioning (HVAC), may also increase property basis.
  6. Subtract depreciation expense from net income to determine the passive rental income that’s taxable.

Example of calculating passive rental income tax

Now let’s use hypothetical numbers to illustrate how passive rental income tax is calculated based on the above steps. For depreciation purposes, we’ll assume an investor purchased an SFR home for $120,000, including capitalized closing costs, which includes a lot value of $10,000:

Rental income: $15,000

Operating expenses: -$6,000

Mortgage interest: -$4,320

Net income before depreciation expense: $4,680

Depreciation expense: ($110,000 cost basis / 27.5 yrs.): -$4,000

Passive rental income subject to tax: $680

If an investor is in the 22% tax bracket, taxes due on the passive rental income would be $149.60.

Using losses to offset passive income

There may be cases in which an investor has a loss on a property for tax purposes, such as when rental income is less than expected due to vacancy or operating expenses are higher.

To illustrate, assume the home in the above example had an annual rental income of $14,000 and operating expenses of $7,000, generating passive rental income subject to a tax of -$1,320.

Losses from rental property may be deducted from other positive passive income received in the same tax year, such as income from other rental properties or stock dividends. Any remaining loss can be carried over to future tax years and used to offset positive income.

How to report passive income from a rental property

Rental income is reported on Schedule E (Form 1040), Supplemental Income and Loss, and is attached to an investor’s federal tax return. While it’s possible to fill out Schedule E by hand, correctly calculating depreciation expenses can be complicated, and it can be far too easy to overlook a valuable deduction that will reduce taxable net income.

Signing up for a free account with Stessa is an easy way to automatically track income and expenses, calculate rental property depreciation, and make tax time a breeze. Simply enter the rental property address, link bank and mortgage accounts, and monitor the financial performance of each rental property—and entire property portfolios—from the comprehensive owner dashboard.

When tax time rolls around, the Stessa Tax Center provides a personalized tax package, along with other valuable tax resources, including information created in partnership with The Real Estate CPA and a TurboTax discount exclusively for members of the Stessa Community.

Closing thoughts

Investing in rental property provides many benefits, including recurring cash flow, profit from equity appreciation over the long term, and unique tax benefits. With a few exceptions, income from rental property is treated as passive income for tax purposes and not subject to payroll tax, with taxes paid based on an investor’s tax bracket.

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Is rental income passive or active? Why it matters (2024)


Is rental income passive or active? Why it matters? ›

Passive income is revenue that takes negligible effort to acquire. It includes earnings from rental properties, limited partnerships, and other projects where you're not involved in the continued generation of earnings.

Is rental income active or passive? ›

The IRS considers a rental activity to be passive if real estate is used by tenants and rental income (or expected rental income) is received mainly for the use of the property. In other words, owning a rental property and collecting rental income is considered passive and not active in most cases.

Are rentals good passive income? ›

Investing in rental properties offers numerous advantages, such as steady cash flow, long-term equity growth, and specific tax perks. In most cases, rental income is considered passive for tax purposes, exempt from payroll taxes, with taxes determined by the investor's tax bracket.

Why is active and passive income important? ›

Combining both active and passive income sources can lead to potential tax advantages, such as the ability to offset capital gains with losses or tax-advantaged investment strategies. With a more diverse set of assets and income sources, you're in a better position to take advantage of some favorable tax laws.

Why passive income is better than earned income? ›

Earned income will always be subject to high taxes. Earned income should be used to quickly build wealth, but in order to minimize your tax position, your wealth should be moved into passive and portfolio income streams. Earned income is subject to your full marginal tax rate and FICA taxes.

Why is rental income passive? ›

In most cases, income received from a rental property is treated as passive income for tax purposes. That means an investor generally doesn't need to withhold or pay payroll taxes because most investors own rental property in addition to having a job.

Is Airbnb active or passive income? ›

Short-term rentals are considered to generate passive income. However, based on the work that you do for the rental property, you are considered to be active participants. This means that you may be able to use some of the losses from the rental to offset income that is not passive income.

Can you live off owning rental property? ›

You're on the right road to rely on your rental income if it comfortably covers all of your expenses, including personal living expenses, mortgage payments, property taxes, insurance, and maintenance fees.

How do I make my rental property active income? ›


If you actively participate in real estate activities—for example, if you make management decisions and you own more than 10% interest in the real estate trade or business—then the income will not be considered passive.

Is being a landlord a good source of income? ›

Rental income can cover almost all costs associated with renting out properties. Good retirement income. Real estate investments can be very lucrative and successful during your golden years. Though being a landlord is difficult, it is a great way to provide for your retirement years.

What are the cons of passive income? ›

1) upfront Investment: Setting up passive income frequently needs an upfront time or financial investment, such as buying stocks or real estate. 2) Unpredictability: Because it may change depending on variables like market circ*mstances, interest rates, or property prices, passive income can be unpredictable.

Why is passive better than active? ›

Some of the key benefits of passive investing are: Ultra-low fees: No one picks stocks, so oversight is much less expensive. Passive funds simply follow the index they use as their benchmark. Transparency: It's always clear which assets are in an index fund.

What does the IRS consider passive income? ›

There are two kinds of passive activities. Trade or business activities in which you don't materially participate during the year. Rental activities, even if you do materially participate in them, unless you're a real estate professional.

Does the IRS consider rental income as earned income? ›

Rental income is typically considered to be unearned income by the IRS. Unlike earned income, which primarily includes wages, salaries, or business income from active participation, unearned income typically includes sources such as interest, dividends, and rental income from real estate.

Why isn't passive income taxed? ›

Passive income is named as such because it doesn't require any regular action on your part; once you have the stream established, it can mostly be set and forgotten. Generally speaking, passive income is taxed the same as active income.

How to not pay taxes on passive income? ›

Here are seven tried-and-true passive income strategies that are tax-free.
  1. Buy Tax-Free Municipal Bonds. ...
  2. Open a Roth IRA and Invest. ...
  3. Sell Your Home. ...
  4. Earn Long-Term Capital Gains. ...
  5. Collect Social Security Benefits. ...
  6. Get Disability Insurance. ...
  7. Invest In an HSA. ...
  8. Bottom Line.
Nov 22, 2023

What type of income is rental income? ›

You generally must include in your gross income all amounts you receive as rent. Rental income is any payment you receive for the use or occupation of property. Expenses of renting property can be deducted from your gross rental income. You generally deduct your rental expenses in the year you pay them.

How does rental income affect your taxes? ›

The IRS treats rental income as regular income for tax purposes. This means you'll need to add your rental income to any other income sources you may have when you file your taxes.

How does the IRS know if I have rental income? ›

Ways the IRS can find out about rental income include routing tax audits, real estate paperwork and public records, and information from a whistleblower. Investors who don't report rental income may be subject to accuracy-related penalties, civil fraud penalties, and possible criminal charges.

Does rental income affect Social Security? ›

Rental income you receive from real estate does not count for Social Security purposes unless: You receive rental income in the course of your trade or business as a real estate dealer (see §§1214-1215); Services are rendered primarily for the convenience of the occupant of the premises (see §1218); or.

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