If you own residential or commercial property and earn income by renting it out, then you must pay taxes on your earnings just as you do any wages or salaries that you earn. What you must pay in taxes depends upon what type of investor you are classified as by the Internal Revenue Service. How your rental property taxes are discerned by the IRS depends upon if the IRS views you as an active investor or a passive investor
Active investors are those who operate their investment properties as a business. The majority of their annual earnings come from their rental properties and they spend 750 or more hours throughout the tax year operating the property as a business. Active investors are also termed “real estate professionals” by the IRS, since their rental property businesses are considered their primary occupation.
Because active investors’ rentals are viewed as a business, they are treated as such for tax purposes. Active investors can deduct losses they incur from their business activities from their other sources of income like salaries, wages and dividends. Active investors also can deduct startup expense and home office expenses from their taxes.
Passive investors are those who have rental properties but the earnings that they receive from them serve as a supplement or second income to their primary occupation. They still have a full-time or part-time job and the earnings that they receive from their rentals are merely extra money for shopping, debts, vacation funds or other savings funds.
Because passive investors’ rentals are viewed as secondary income, they can only deduct the normal costs associated with their rental properties. They cannot deduct any home office expenses and are limited on how much they can deduct from any losses they might incur. As of 2010, you can only deduct up to $3,000 from your other active income like your job or employment.
However, there is another way to avoid the passive income trap. Call me for more details.