It's a dream for many—achieve a steady stream of money that works for you while you do something else, like travel, work a different job, or stay home with the kids, but tax implications are everywhere and quickly become complex. There are many things you need to consider when evaluating the right mix between passive and active income.
Passive Stays with Passive
In the eyes of the IRS, passive losses can only come out of passive income, so if you see major losses from rental properties and you net only a small amount of income from those properties, you will feel the negative effects. We'll talk about exceptions—there are many—but in general, it's good to know how the government sees this income at the very highest level. For most non-professionals or those with small incomes, it's going to be a challenge to find a way to have income from one stream (passive) offset or benefit you based on income from a different stream (active.)
Evaluating Active Income Mix
No one can tell you the right mix between active and passive income because it's something only you can determine for yourself. That aside, there are still factors you need to consider:
If you are claiming to get a majority of your income from passive means in the rental property business, you are probably well on your way to becoming a true real estate professional. You will want to thoroughly research all the pros and cons of becoming one in the eyes of tax law.
Passive versus Your Active AGI
Another thing to consider in determining the risk balance of passive versus active income is knowing that you can deduct up to $25,000 worth of passive losses and have it be offset by any ordinary income in a tax year. But here's the hook: Once you start looking at the higher income brackets, it starts to phase out—and phase out quickly. For example, the benefit starts scaling down for married taxpayers starting at $100,000 worth of adjusted gross income (AGI) and is eliminated after $150,000 of AGI.
Should You Become a Professional?
If your property portfolio gets so complex that you are getting dinged at tax time, you might consider becoming a real estate professional. By doing so, the tax code will treat you differently, and in some cases, better. Again, as with any tax question, talk to someone who knows what they are doing and weigh the pros and cons carefully. Rules around passive versus active income can be confusing.
Know Your Exceptions
There are also exceptions to the passive loss/passive income rule when it comes to real estate. One example of this is if you deal in short-term rentals like a vacation property—having tenants for 7 days or fewer at a time—or if the property is rented for 30 days or fewer and you have a substantial investment in personal services surrounding that property. There are more exceptions to consider when it comes to passive loss/passive income, so consult someone who is familiar with this area of real estate tax law.
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