The goal of every investor is to generate more income than expenses incurred. As long as cash inflows exceed cash outflows, you’re happy – I mean, income is income, right?
We’re dealing with two separate classes of income here – active and passive. There are major differences between the two that can greatly affect your wallet, either positively or negatively.
After reading this article, you will have a better understanding of how to structure your investments in a way that works best for you and your pocket.
Let’s start by defining active and passive income.
What Is Active Income?
Active income is income earned as a result of performing a service or from a trade or business in which you materially participate (more on material participation later). You are actively involved in the generation of income.
Examples of active income include:
- Property management
- Lending (as a business)
- Certain transient/short-term (Airbnb, VRBO, etc.) rental income
- Income from other trades or businesses in which you materially participate
What Is Passive Income?
Passive income is income derived from a source in which you are not actively involved. It’s more of a hands-off investment that generates income for you without much work on your part.
Sounds much better than active income, right? That’s because it is!
Examples of passive income include:
- Rental income
- Syndications (limited partner)
- Real estate investment trusts (REITs)
- Income from other trades or businesses in which you do not materially participate
As mentioned above, income from trades or businesses in which you materially participate is considered active income. But what exactly is “material participation”?
Publication 925 states that you materially participate in a trade or business activity (TOBA) if you meet any one of the following seven tests:
- Your participation > 500 hours.
- Your participation was substantially all of the participation in the TOBA.
- Your participation > 100 hours and no one participated more than you.
- The TOBA is a significant participation activity (SPA) and you participated in all SPAs for more than 500 hours. SPA – any TOBA in which participation > 100 hours for the year and you didn’t meet any of the other material participation tests, other than this one (#4).
- You materially participated in five (aggregate) out of the last ten years.
- The TOBA is a personal service activity in which you materially participated for any three (aggregate) preceding tax years.
- You participated (over 100 hours) on a regular, continuous, and substantial basis throughout the year.
Now that we have an understanding of what active income, passive income, and material participation is, let’s see how the different classes of income (active vs. passive) can affect your tax bill.
Active and passive income are both taxed at ordinary tax rates but there are stark differences between the two.
Active income is subject to Social Security and Medicare taxes (6.2% and 1.45%, respectively). Social Security tax is paid until gross earnings exceed the Social Security wage base ($128,700 in 2018).
If you’re an employee, these taxes are deducted directly from your paycheck; I’m sure you’re familiar with everyone’s best friend, FICA.
If you’re self-employed or run a side business, you pay self-employment (SE) tax on your business income upon filing your tax return. As a self-employed individual, you must pay both the employer and employee share of Social Security and Medicare taxes, for a total of 15.3%.
Therefore, non-wage active income is taxed at your ordinary rates plus SE tax of 15.3%. If you’re in the top bracket (37%), you could wind up paying over 50% in taxes on your active self-employment income.
And that doesn’t even factor in state taxes.
Passive income is not subject to Social Security and Medicare taxes, which provides a huge tax advantage compared to active income.
On the other hand, passive income is typically subject to the Net Investment Income Tax (NIIT) of 3.8%, whereas active income is not.
One of the best tax benefits of passively investing in real estate, specifically rental properties, is the ability to generate a tax loss—through the magic of depreciation—while still being cash flow positive.
Passive tax losses, however, are not as friendly as active losses. Passive losses can only be used to offset passive income. Additionally, passive losses in excess of passive income generally cannot be deducted in the current year; they are carried over and used to offset future passive income. There are exceptions to the passive activity loss (PAL) rules, though (more on this later).
Alternatively, there’s no limit to the amount of active losses you can report. Active losses can be used to offset, and even exceed, any and all income. Excess losses create what’s called a net operating loss (NOL), which can be carried over to future years.
Given the possibility of the substantial negative tax impacts of active income (high tax liability) and passive losses (limited deductibility), it’s extremely important to actively tax plan with your CPA to make sure you’re in the best position to maximize your tax savings.
Entity structure plays an important role in helping minimize tax liability. For example, S Corps can help shelter some income from SE tax and, thanks to the new Tax Cuts and Jobs Act, C Corps offer an appealingly low flat tax rate of 21%.
As mentioned above, passive losses that exceed passive income are not deductible; they are carried over to future years. If you have excess passive losses that are being carried over, it may prove to be beneficial to restructure some of your investments to generate passive income, which would be offset by the passive loss carryovers.
Every scenario is different and requires unique planning, which is why it’s imperative to maintain a constant and continuous dialogue with your tax advisor throughout the year.
Exceptions to the PAL Rules
In certain scenarios, excess passive activity losses can be deducted against other income:
- Depending on your income, you may be able to deduct up to $25,000 of passive losses against nonpassive income.
- If you are a qualified real estate professional by IRS standards, passive real estate activities are considered active and losses can be deducted in full.
Each of these two exceptions will be covered in further detail in the next two articles. Until then, please feel free to reach out if you have any questions or would like to discuss these topics further.
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Nick Aiola is a CPA located in New York, NY. Nick provides the highest quality of tax and accounting services to a wide range of clients, specializing in servicing real estate investors and individuals and business owners in the real estate industry.
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