April 1, 2025 • 14 mins
What Is The Difference Between Passive And Non-Passive Rental Income?
The complex world of real estate taxation contains hidden opportunities that could dramatically impact your bottom line—if you know where to look. Brian Moss, a senior tax associate with MP CPAs who recently passed all four parts of his CPA exam, breaks down the critical distinction between passive and non-passive rental income classification that every property owner needs to understand.
Most property owners don't realize that rental income defaults to passive status, severely limiting how losses can offset other income sources. Brian walks us through exactly what it takes to potentially reclassify your rental activities as non-passive, unlocking significant tax advantages. He details the dual requirements of material participation (requiring regular, continuous involvement) and real estate professional status (demanding more than 50% of your personal services and 750+ annual hours in real property businesses).
Whether you're a seasoned real estate investor or considering your first property purchase, this episode delivers actionable insights that could potentially save you thousands in taxes through proper planning and documentation.
To learn more about MP CPAs visit:
https://thempgroupcpa.com/
MP CPAs
413-739-1800
Mark as Played
Transcript
Episode Transcript
Available transcripts are automatically generated. Complete accuracy is not guaranteed.
Speaker 1 (00:01):
Welcome to the Knowing what Counts podcast, the
place where expert guidancemeets smart financial decisions.
Whether you're a high net worthindividual or a thriving
business, the experts at MPCPAsare here to help you protect and
optimize your wealth.
Let's get started, becausesuccess begins with Knowing what
(00:22):
Counts.
Because success begins withknowing what counts.
Speaker 2 (00:27):
Unlock expert accounting insights tailored for
real estate professionals withProperty Pioneers, helping you
optimize finances and maximizeprofits.
Welcome back everyone.
I'm Sofia Yvette, co-host slashproducer, here in the studio
today with real estateprofessional Brian Moss, a
(00:48):
senior tax associate with MPCPAs.
Brian, how's it going?
Speaker 3 (00:54):
I'm doing pretty good , thank you.
How about yourself?
Speaker 2 (00:57):
I'm doing well.
So, brian, tell us a bit aboutyourself.
Speaker 3 (01:02):
Absolutely so.
I've been working with MP sincethe beginning of 2022.
I started off as an internwhile I was finishing up my
undergrad at Western New EnglandUniversity.
Then I jumped right in herefull time after that.
While I've been here, I've beenpursuing my CPA license.
I just recently found out thatI've passed all four parts of
the exam, so it's exciting, fromthis point on, to be working
(01:25):
towards getting the requiredcredits to finish up my
licensure, and I think, whileI've been here, it's been a
great opportunity to learn a lot, and I'm happy to have a chance
to share some of that, whatI've learned, with everybody
who's listening today.
Speaker 2 (01:39):
Well, that is great news.
So, brian, what can you tell usabout the standard rules for
reporting rental activity onyour tax return?
Speaker 3 (01:49):
So for the standard rules for reporting rental
activity on your tax return, bydefault rental activity is
considered a passive activity.
Just to give a little briefexplanation of the comparison
between passive versusnon-passive Passive activity is
mainly derived from activitiesthat you don't really have any
(02:10):
real active involvement in.
Maybe you just make aninvestment in that business that
entitles you to some of theprofits, and rental activity is
one type of activity that is bydefault considered passive.
The tax treatment for rentalactivity and other passive
activities is if you havepassive losses, you can only
(02:31):
deduct those losses on yourreturn to the extent that you
have passive income from othersources to offset that.
So if you hypothetically wouldown multiple rentals, you can
only deduct your rental lossesfrom one property with the
rental income that you have froma different property.
Non-passive activity, on theother hand, doesn't really have
that same type of limitationwhere you need non-passive
(02:53):
income from other sources tooffset it.
You're able to deductnon-passive losses a little bit
more freely than you can withpassive.
Speaker 2 (03:03):
So, brian, are there any ways to allow rental
activity to be treated asnon-passive?
Speaker 3 (03:11):
Yes, there are some ways to change the tax treatment
of your rental activity frompassive to non-passive.
There are really two big partsto the puzzle here, the first
one being you need to havewhat's called material
participation in the activity.
That is a bit of a higherstandard than simply having
(03:33):
active participation, which youcan achieve by just being
involved in some of themanagement and decision-making
types of activities with yourrental property.
For material participationthat's required, there needs to
be more regular, continuous andsubstantial involvement in that
activity.
There are, I think, sevendifferent tests you can kind of
look at to see to make sure thatyou're meeting the standard of
(03:55):
material participation.
You don't need to meet allseven.
As long as you can meet one youshould be set.
I'm not going to list all sevenright now, but to name a couple
that people with rental activitywill sometimes try to reach for
.
If you participate in theactivity for more than 500 hours
during the year, that's afairly common one.
And another test you could lookfor is having your
(04:17):
participation constitutesubstantially all participation
of all individuals.
So essentially, if you're theone doing most or all of the
work towards your activity, thenthat would be a way you could
meet that test.
The material participation isone part of the equation and the
other is meeting the IRSstandards of being a real estate
(04:39):
professional, which I thinkwe're going to be discussing
that a bit more today as well.
But they have some prettystrict rules to get to that real
estate professional standard.
Speaker 2 (04:51):
What can you tell us about the requirements needed to
qualify as a real estateprofessional?
Let's get into it a little more.
Speaker 3 (04:59):
Absolutely so.
In order to be qualified as areal estate professional in the
eyes of the IRS, there are twotests that you must satisfy.
In this case, you have to meetboth of them.
You can't just pick one.
The first test is that morethan 50% of your personal
services must be in realproperty business.
The other test is that morethan 750 hours per year must be
(05:22):
spent in real property business.
The second test there istypically not quite as
challenging for people to meetcompared to the first one.
That first one can beespecially hard to get to if you
also have another full-time joboutside of rental activities,
if you have a job where you work40 hours a week that's not
related to your rentals.
In order to meet that firsttest, you must also be able to
(05:45):
prove that you are putting inover 40 hours a week towards the
rental activities to meet thatone, and that's kind of a hard
sell for the IRS.
They haven't really found thatto be very believable in a lot
of cases in the past.
That being said, though, thereare some professions and jobs
out there that can count towardsthe hours needed to meet these
two tests.
(06:06):
Essentially, any job that youwork in that is related to real
estate, development,construction management, leasing
, working as a real estatebroker or agent the hours you
spend there can count towardsthese two tests.
The one caveat for that, though, is you must be working as an
independent contractor or soleproprietor in one of these
(06:27):
professions.
If you're simply an employeeworking in a career like this,
you must own at least 5% of thebusiness to count this time
towards the real estateprofessional tests.
There are a few types of rentaland real estate related
activities that do not count ashours spent towards these two
tests, that people don't alwaysknow about, so those are time
(06:50):
spent with real estate investing, traveling to and from your
rental properties and time spentresearching topics related to
real estate and rentals and need.
Hours spent there cannot applytowards these two tests.
Speaker 2 (07:04):
Wow.
What records or support shouldpeople maintain as proof that
they meet the two real estateprofessional tests?
Speaker 3 (07:13):
So for the two real estate professional tests it's
pretty strict on what kind ofdocumentation you need.
It's really important that youmaintain contemporaneous
documentation that's recorded atthe time you're performing it.
Anything that's kind of alittle bit more like ballpark
estimates or after the fact, theIRS has not really found that
(07:36):
to be sufficient to prove you'remeeting the real estate
professional standards in thepast.
So it's vital that you keeptime logs that reflect the hours
in which you're performingservices.
That also means that goestowards only hours that you are
actually performing work, simplybeing on call or available if
(07:56):
you're needed at a property.
Time spent like that cannotreally count towards the real
estate professional tests.
Speaker 2 (08:04):
And so how do these rules apply to people who own
multiple rental properties?
Speaker 3 (08:15):
rental properties.
So, for someone who ownsmultiple rental properties, the
default rule is that you mustmeet the real estate,
professional and materialparticipation standards for each
property separately.
If you own a lot of properties,that can be pretty hard to do,
and only the properties that youactually meet those tests for
are the ones that would get thatnon-passive treatment.
That being said, though, youhave an option to make an
(08:35):
election with your tax return togroup all of your rental
properties together into onesingle economic unit or one
single activity, and as long asthat election is made, then all
of the time spent throughout allof your properties can come
together and apply to meetingthe tests for that one activity
that you've grouped them alltogether, as on your return.
(08:57):
So that could certainly be apotentially advantageous
strategy to consider when filingyour return if you own multiple
properties.
Speaker 2 (09:07):
So can someone who hires the services of a real
estate management company stillmeet the real estate
professional status?
Someone who hires a real estatemanagement company still meet
the real estate professionalstatus?
Speaker 3 (09:14):
Someone who hires a real estate management company
can still meet that real estateprofessional status.
It can be a little bit trickier, and it all comes down to
making sure that you have theproper documentation to
substantiate that you are stillthe primary person involved in
managing the day-to-dayoperations of the company.
(09:35):
You are still substantiallyinvolved in everything that's
going on and you're not simplyjust checking off or approving
decisions that the managementcompany is making for you.
So you're going to want to makesure that you have it laid out
very clearly.
These are the things that I amdoing and I'm responsible for,
versus these are the things thatthe management company is doing
and what they are responsiblefor.
So this needs to be very clearthat you're not just handing off
(09:58):
the reins to them and lettingthem take control of everything
for you.
Speaker 2 (10:03):
What are the most common mistakes people make when
trying to qualify as a realestate professional?
Speaker 3 (10:09):
So a lot of the most common mistakes typically all
come back to not having enoughsupporting documentation to
prove you're actually meetingall of these pretty strict tests
that they put forward.
Related to that was a case backin 2019, harrison v
(10:38):
Commissioner where in thatscenario, there was a married
couple that was filing as realestate professionals on their
tax returns and taking all oftheir rental activity as
non-passive rather than passive.
The court ended up rulingagainst them being able to do
that, saying that neither spousealone was able to prove that
they had met the real estateprofessional status tests or the
material participation tests.
(10:59):
The rules surrounding that arethat if you are filing a joint
return with the spouse, at leastone spouse on their own must
put in enough hours to meet thereal estate professional
standards.
You cannot pool together thehours of both spouses to get
that treatment.
What's interesting here is thatin this case, the married couple
(11:20):
did have pretty clear recordsshowing what work was performed,
how long they spent doing it.
What they failed to do was haveany clear specification as to
which spouse was performingwhich task, so there was a lot
of uncertainty whether one ofthem alone was putting in enough
hours to meet the tests, kindof to make matters worse for
(11:43):
them too.
The courts had also determinedthat the calendars and records
they had kept did not accuratelyreflect the hours of activity
performed.
There were a lot of cases wherethey had recorded a full hour
for performing some trivialtasks that don't really take an
hour to do, such as spend a fullhour just receiving payments or
paying a mortgage stuff thatreally only takes a couple
(12:06):
minutes.
They would put a full hourspent doing it.
So it was kind of theimpression that they may have
been inflating some of theirhours a little bit.
And then another mistake thatthey had made, unfortunately for
them, was that they hadreported a lot of hours towards
simply watching contractorsperform their work, which, as we
were discussing earlier, thetime spent to meet the real
(12:28):
estate professional and materialparticipation tests have to be
work that you are actuallyactively performing.
Simply being on call oravailable or supervising in this
case is not really enough tocut it to meet those hours.
Speaker 2 (12:43):
Wow.
Any final thoughts or comments?
Speaker 3 (12:46):
Sure.
So, as we've been discussing,it is pretty tough in some cases
to qualify for these tests,with how strict the IRS really
gets about verifying whether ornot you meet the real estate
professional standards.
In the event that you may notbe able to meet these tests but
still want to find a way totreat your rental activity as
(13:09):
non-passive, there is anotheroption you could consider, which
would be to operate your rentalbusiness as a short-term rental
.
In that case, that essentiallyjust means that the average stay
of your tenants is seven daysor less, although, to get
non-passive treatment with thismethod, you would still need to
have the material participationelement present there.
Speaker 2 (13:33):
Love it, Brian.
We'll catch you on the nextepisode.
Have a fantastic rest of yourday.
Speaker 3 (13:38):
Thank you, you do the same.
Speaker 1 (13:40):
Thanks for listening to the Knowing what Counts
podcast.
Ready to optimize your wealthand protect your future, visit
the mpgroupscpacom or call413-739-1800 to connect with our
team of experts.
Remember, success is aboutknowing what counts.
Welcome to the Knowing what Counts podcast, the
place where expert guidancemeets smart financial decisions.
Whether you're a high net worthindividual or a thriving
business, the experts at MPCPAsare here to help you protect and
optimize your wealth.
Let's get started, becausesuccess begins with Knowing what
(00:22):
Counts.
Because success begins withknowing what counts.
Speaker 2 (00:27):
Unlock expert accounting insights tailored for
real estate professionals withProperty Pioneers, helping you
optimize finances and maximizeprofits.
Welcome back everyone.
I'm Sofia Yvette, co-host slashproducer, here in the studio
today with real estateprofessional Brian Moss, a
(00:48):
senior tax associate with MPCPAs.
Brian, how's it going?
Speaker 3 (00:54):
I'm doing pretty good , thank you.
How about yourself?
Speaker 2 (00:57):
I'm doing well.
So, brian, tell us a bit aboutyourself.
Speaker 3 (01:02):
Absolutely so.
I've been working with MP sincethe beginning of 2022.
I started off as an internwhile I was finishing up my
undergrad at Western New EnglandUniversity.
Then I jumped right in herefull time after that.
While I've been here, I've beenpursuing my CPA license.
I just recently found out thatI've passed all four parts of
the exam, so it's exciting, fromthis point on, to be working
(01:25):
towards getting the requiredcredits to finish up my
licensure, and I think, whileI've been here, it's been a
great opportunity to learn a lot, and I'm happy to have a chance
to share some of that, whatI've learned, with everybody
who's listening today.
Speaker 2 (01:39):
Well, that is great news.
So, brian, what can you tell usabout the standard rules for
reporting rental activity onyour tax return?
Speaker 3 (01:49):
So for the standard rules for reporting rental
activity on your tax return, bydefault rental activity is
considered a passive activity.
Just to give a little briefexplanation of the comparison
between passive versusnon-passive Passive activity is
mainly derived from activitiesthat you don't really have any
(02:10):
real active involvement in.
Maybe you just make aninvestment in that business that
entitles you to some of theprofits, and rental activity is
one type of activity that is bydefault considered passive.
The tax treatment for rentalactivity and other passive
activities is if you havepassive losses, you can only
(02:31):
deduct those losses on yourreturn to the extent that you
have passive income from othersources to offset that.
So if you hypothetically wouldown multiple rentals, you can
only deduct your rental lossesfrom one property with the
rental income that you have froma different property.
Non-passive activity, on theother hand, doesn't really have
that same type of limitationwhere you need non-passive
(02:53):
income from other sources tooffset it.
You're able to deductnon-passive losses a little bit
more freely than you can withpassive.
Speaker 2 (03:03):
So, brian, are there any ways to allow rental
activity to be treated asnon-passive?
Speaker 3 (03:11):
Yes, there are some ways to change the tax treatment
of your rental activity frompassive to non-passive.
There are really two big partsto the puzzle here, the first
one being you need to havewhat's called material
participation in the activity.
That is a bit of a higherstandard than simply having
(03:33):
active participation, which youcan achieve by just being
involved in some of themanagement and decision-making
types of activities with yourrental property.
For material participationthat's required, there needs to
be more regular, continuous andsubstantial involvement in that
activity.
There are, I think, sevendifferent tests you can kind of
look at to see to make sure thatyou're meeting the standard of
(03:55):
material participation.
You don't need to meet allseven.
As long as you can meet one youshould be set.
I'm not going to list all sevenright now, but to name a couple
that people with rental activitywill sometimes try to reach for
.
If you participate in theactivity for more than 500 hours
during the year, that's afairly common one.
And another test you could lookfor is having your
(04:17):
participation constitutesubstantially all participation
of all individuals.
So essentially, if you're theone doing most or all of the
work towards your activity, thenthat would be a way you could
meet that test.
The material participation isone part of the equation and the
other is meeting the IRSstandards of being a real estate
(04:39):
professional, which I thinkwe're going to be discussing
that a bit more today as well.
But they have some prettystrict rules to get to that real
estate professional standard.
Speaker 2 (04:51):
What can you tell us about the requirements needed to
qualify as a real estateprofessional?
Let's get into it a little more.
Speaker 3 (04:59):
Absolutely so.
In order to be qualified as areal estate professional in the
eyes of the IRS, there are twotests that you must satisfy.
In this case, you have to meetboth of them.
You can't just pick one.
The first test is that morethan 50% of your personal
services must be in realproperty business.
The other test is that morethan 750 hours per year must be
(05:22):
spent in real property business.
The second test there istypically not quite as
challenging for people to meetcompared to the first one.
That first one can beespecially hard to get to if you
also have another full-time joboutside of rental activities,
if you have a job where you work40 hours a week that's not
related to your rentals.
In order to meet that firsttest, you must also be able to
(05:45):
prove that you are putting inover 40 hours a week towards the
rental activities to meet thatone, and that's kind of a hard
sell for the IRS.
They haven't really found thatto be very believable in a lot
of cases in the past.
That being said, though, thereare some professions and jobs
out there that can count towardsthe hours needed to meet these
two tests.
(06:06):
Essentially, any job that youwork in that is related to real
estate, development,construction management, leasing
, working as a real estatebroker or agent the hours you
spend there can count towardsthese two tests.
The one caveat for that, though, is you must be working as an
independent contractor or soleproprietor in one of these
(06:27):
professions.
If you're simply an employeeworking in a career like this,
you must own at least 5% of thebusiness to count this time
towards the real estateprofessional tests.
There are a few types of rentaland real estate related
activities that do not count ashours spent towards these two
tests, that people don't alwaysknow about, so those are time
(06:50):
spent with real estate investing, traveling to and from your
rental properties and time spentresearching topics related to
real estate and rentals and need.
Hours spent there cannot applytowards these two tests.
Speaker 2 (07:04):
Wow.
What records or support shouldpeople maintain as proof that
they meet the two real estateprofessional tests?
Speaker 3 (07:13):
So for the two real estate professional tests it's
pretty strict on what kind ofdocumentation you need.
It's really important that youmaintain contemporaneous
documentation that's recorded atthe time you're performing it.
Anything that's kind of alittle bit more like ballpark
estimates or after the fact, theIRS has not really found that
(07:36):
to be sufficient to prove you'remeeting the real estate
professional standards in thepast.
So it's vital that you keeptime logs that reflect the hours
in which you're performingservices.
That also means that goestowards only hours that you are
actually performing work, simplybeing on call or available if
(07:56):
you're needed at a property.
Time spent like that cannotreally count towards the real
estate professional tests.
Speaker 2 (08:04):
And so how do these rules apply to people who own
multiple rental properties?
Speaker 3 (08:15):
rental properties.
So, for someone who ownsmultiple rental properties, the
default rule is that you mustmeet the real estate,
professional and materialparticipation standards for each
property separately.
If you own a lot of properties,that can be pretty hard to do,
and only the properties that youactually meet those tests for
are the ones that would get thatnon-passive treatment.
That being said, though, youhave an option to make an
(08:35):
election with your tax return togroup all of your rental
properties together into onesingle economic unit or one
single activity, and as long asthat election is made, then all
of the time spent throughout allof your properties can come
together and apply to meetingthe tests for that one activity
that you've grouped them alltogether, as on your return.
(08:57):
So that could certainly be apotentially advantageous
strategy to consider when filingyour return if you own multiple
properties.
Speaker 2 (09:07):
So can someone who hires the services of a real
estate management company stillmeet the real estate
professional status?
Someone who hires a real estatemanagement company still meet
the real estate professionalstatus?
Speaker 3 (09:14):
Someone who hires a real estate management company
can still meet that real estateprofessional status.
It can be a little bit trickier, and it all comes down to
making sure that you have theproper documentation to
substantiate that you are stillthe primary person involved in
managing the day-to-dayoperations of the company.
(09:35):
You are still substantiallyinvolved in everything that's
going on and you're not simplyjust checking off or approving
decisions that the managementcompany is making for you.
So you're going to want to makesure that you have it laid out
very clearly.
These are the things that I amdoing and I'm responsible for,
versus these are the things thatthe management company is doing
and what they are responsiblefor.
So this needs to be very clearthat you're not just handing off
(09:58):
the reins to them and lettingthem take control of everything
for you.
Speaker 2 (10:03):
What are the most common mistakes people make when
trying to qualify as a realestate professional?
Speaker 3 (10:09):
So a lot of the most common mistakes typically all
come back to not having enoughsupporting documentation to
prove you're actually meetingall of these pretty strict tests
that they put forward.
Related to that was a case backin 2019, harrison v
(10:38):
Commissioner where in thatscenario, there was a married
couple that was filing as realestate professionals on their
tax returns and taking all oftheir rental activity as
non-passive rather than passive.
The court ended up rulingagainst them being able to do
that, saying that neither spousealone was able to prove that
they had met the real estateprofessional status tests or the
material participation tests.
(10:59):
The rules surrounding that arethat if you are filing a joint
return with the spouse, at leastone spouse on their own must
put in enough hours to meet thereal estate professional
standards.
You cannot pool together thehours of both spouses to get
that treatment.
What's interesting here is thatin this case, the married couple
(11:20):
did have pretty clear recordsshowing what work was performed,
how long they spent doing it.
What they failed to do was haveany clear specification as to
which spouse was performingwhich task, so there was a lot
of uncertainty whether one ofthem alone was putting in enough
hours to meet the tests, kindof to make matters worse for
(11:43):
them too.
The courts had also determinedthat the calendars and records
they had kept did not accuratelyreflect the hours of activity
performed.
There were a lot of cases wherethey had recorded a full hour
for performing some trivialtasks that don't really take an
hour to do, such as spend a fullhour just receiving payments or
paying a mortgage stuff thatreally only takes a couple
(12:06):
minutes.
They would put a full hourspent doing it.
So it was kind of theimpression that they may have
been inflating some of theirhours a little bit.
And then another mistake thatthey had made, unfortunately for
them, was that they hadreported a lot of hours towards
simply watching contractorsperform their work, which, as we
were discussing earlier, thetime spent to meet the real
(12:28):
estate professional and materialparticipation tests have to be
work that you are actuallyactively performing.
Simply being on call oravailable or supervising in this
case is not really enough tocut it to meet those hours.
Speaker 2 (12:43):
Wow.
Any final thoughts or comments?
Speaker 3 (12:46):
Sure.
So, as we've been discussing,it is pretty tough in some cases
to qualify for these tests,with how strict the IRS really
gets about verifying whether ornot you meet the real estate
professional standards.
In the event that you may notbe able to meet these tests but
still want to find a way totreat your rental activity as
(13:09):
non-passive, there is anotheroption you could consider, which
would be to operate your rentalbusiness as a short-term rental
.
In that case, that essentiallyjust means that the average stay
of your tenants is seven daysor less, although, to get
non-passive treatment with thismethod, you would still need to
have the material participationelement present there.
Speaker 2 (13:33):
Love it, Brian.
We'll catch you on the nextepisode.
Have a fantastic rest of yourday.
Speaker 3 (13:38):
Thank you, you do the same.
Speaker 1 (13:40):
Thanks for listening to the Knowing what Counts
podcast.
Ready to optimize your wealthand protect your future, visit
the mpgroupscpacom or call413-739-1800 to connect with our
team of experts.
Remember, success is aboutknowing what counts.
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