Passive Income & Taxes: What Investors Need To Know

Key Takeaways


Passive income is the money an investor stands to make from an activity in which they are not actively involved. Earnings are not directly correlated to the amount of time one invests in a particular endeavor. Rental properties, for example, have developed a reputation for awarding real estate investors with passive income in the form of cash flow. Traditionally, rental property owners can collect cash flow from a real estate asset with little to no effort on their behalf. With the help of a property management company, landlords may be able to collect rent without investing any more of their time. While treated differently by the Internal Revenue Service (IRS), passive income is taxable more often than not.

However, while most are familiar with the concept of a passive income rental property, few are actually aware of just how good of an investment they can be. Of course, the right property will attract tenants with monthly cash flow, but it is important to note that the benefits of a rental property extend far beyond that of the capital they bring in. In fact, you could argue that the cash flow is a bonus, coming in a close second to passive income tax benefits. For what it’s worth, the tax benefits associated with a passive income property can very well be the most attractive asset sought out by landlords.

What Is An Example Of Passive Income?

There are several ways to earn passive income, but for the sake of this article, we will focus on the one real estate investors care about the most: rental properties. If for nothing else, rental properties represent the pinnacle of real estate investing. For starters, cash-flowing rental properties are proven, wealth-building vehicles, but that’s not all; they allow their owners to make money without adding any more work to their schedule. By definition, passive income is earnings derived from a rental property where an investor is not actively involved.


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passive income tax rate

Passive Income Tax Benefits For Real Estate Investors

Everyone knows how profitable the right passive income property in the ideal location can be, but the same properties often coincide with more impressive tax benefits and deductions. However, far too many investors overlook the deductions they can make when filing their taxes. Having said that, approaching tax season with acute attention to detail and an understanding of the deductions awarded to passive income investors can mean the difference between a profitable rental property and losing money on your real estate venture.

If you own a rental property, investor or not, you are entitled to certain deductions by the IRS. That said, nobody is going to hold your hand and tell you which deductions you can legally make; it’s up to you to familiarize yourself with them. So whether you are a passive income investor yourself or are simply curious as to which deductions landlords can make come tax time, here are a few of the passive income tax benefits you won’t want to miss out on:

  • Rental property owners may deduct they interest they pay on their mortgage each year.

  • Repairs to the property may be deducted in the event they are ordinary, necessary, and reasonable in amount.

  • Landlords may deduct the amount of money they spend traveling for the sake of running and maintaining the property.

  • Rental property owners may deduct their home office; provided it meets the minimal criteria.

  • Depreciation losses permit the owners of rental properties to write off the cost of the home over a predetermined period of time.

1. Interest

If the interest a landlord pays on their mortgage isn’t their biggest expense, it is certainly close to it. Even with rates as low as they are today, interest payments are a sizable cost that needs to be accounted for. Nonetheless, for as intimidating as interest payments can be, they are not without their benefits. Mortgage interest has become synonymous with one of the largest deductions landlords can make. Passive income investors can deduct mortgage interest payments on loans used to acquire or improve a rental property. However, it is important to note that they can also deduct the interest paid on credit cards specifically used to maintain rental property activity.

2. Repairs

Slightly more ambiguous than their interest deduction counterpart, repairs can only be deducted if they are ordinary, necessary, and reasonable in amount. That said, repairs can only be deducted in the year in which they are made. Common repairs that can be deducted from your taxes come April: fixing leaks, repainting, plastering, replacing broken windows, and fixing floors.

It is important to note, however, that repairs and improvements are not one in the same; there are slight differences between the two. As a passive income investor, it is in your best interest to differentiate between repairs and improvements. For clarification, I would like to refer you to how the IRS defines an improvement:

  • The changes make a long-term asset much better than it was before

  • The changes restore a subject asset to operating condition

  • The changes adapt an asset to a new use

If you are looking to deduct repairs, they can’t fall within any of the aforementioned categories. Instead, to be able to deduct repairs from your passive income property, any expenses you incur can’t result in the betterment, restoration, or adaptation of a property’s features.

3. Travel Resulting From Rental Activity

Far too many passive income investors are not aware of the tax deductions extending beyond a property’s physical upkeep. Having said that, it is entirely possible to deduct the amount of money you spend traveling for the sake of running and maintaining the property. Anywhere you drive for the sake of the rental, which includes visits to the property itself, can amount to travel expenses. Most notably, you can deduct the actual expenses incurred while traveling (gas, upkeep, repairs, etc.). To clarify, travel expenses must be common, helpful, appropriate for your rental activity, and—above all else—be solely for rental activities. Much like the repairs made on a property, deductions resulting from travel costs must be made in the same year they were incurred.

4. Home Office

Passive income investors, not unlike most professionals that work from home, are allowed to deduct their home office, provided it meets the minimal criteria. What’s more, this deduction helps both renters and homeowners. You can deduct your home office whether you own the home it is in or are simply renting it. However, like every other deduction on this list, the home office must meet certain requirements to qualify for a deduction.

According to NOLO, “the home office deduction is available only if you are running a bona fide business.” That means any work dedicated to your passive income property from the confines of your own home can’t be a hobby. “If the IRS decides that you are indulging a hobby rather than trying to earn a profit, it won’t let you take the home office deduction.”

If you are going to claim a home office deduction, it is in your best interest to prepare to prove said claim. The following steps will help you confirm your home office is the result of a legit business:

  • Photograph your home office to include in your tax folder. Be sure to include a diagram showing the relative size of the office to the living space.

  • Route any mail for your business to your home office address.

  • Include your home address on business cards and stationary of a similar nature.

  • Install a separate phone line to be used solely for business purposes.

  • Keep a log of any clients or customers that visit your home office.

  • Don’t forget to keep track of the time you spend working at home.

5. Depreciation

Otherwise known as depreciation losses, depreciation tax write-offs are essentially the most important tax deduction in a passive income investor’s arsenal. As their name suggests, depreciation losses permit the owners of rental properties to write off the cost of the home over a predetermined period of time. The subject property is essentially a business expense, and therefore can be written off.

However, you can’t write off the entire cost of the property in the same year. According to Brian Dean, Founder of Exploding Topics, “depreciation is the process of deducting a property’s loss in value throughout its estimated life which is 27.5 years for residential property and 39 years for commercial.” Essentially, depreciation can be used to offset costs due to regular use of the property.

The IRS defines depreciation losses as “allowances for exhaustion, wear and tear (including obsolescence) of property.” According to their website, “You begin to depreciate your rental property when you place it in service. You can recover some or all of your original acquisition cost and the cost of improvements by using Form 4562, Depreciation and Amortization, (to report depreciation) beginning in the year your rental property is first placed in service, and beginning in any year you make improvements or add furnishings.”

This passive income tax benefit is to account for the perceived loss in value associated with aging assets. If for nothing else, homes depreciate every day in the eyes of the IRS. This is a way for homeowners to make up for allegedly lost capital. However, and this is the real kicker, while homes may depreciate in the eyes of the IRS, properties actually appreciate more often than they depreciate. More often than not, the loss never actually occurs. Homeowners are therefore able to take advantage of deductions without their assets depreciating. It’s almost too good to be true.

Summary

Passive income tax benefits have the potential to turn a good rental property into a great one. However, as I said before, nobody will hold your hand and tell you to claim the appropriate deductions; you need to make sure you know what is within your legal right to deduct. I encourage all passive income investors to consult a certified public accountant (CPA) to confirm that they are, in fact, taking advantage of all the deductions made available. Please take note of the passive income tax benefits you qualify for and see to it they contribute to your bottom line instead of taking away from it.

Were you aware of all the passive income tax benefits made available to investors? Do they make you want to invest in your own rental property? If so, let us know which benefit you look forward to most in the comments below:


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