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Active vs Passive Investors

Active rental property owners generally get more favorable tax treatment than do passive investors.

When calculating annual taxes rental property owners need to be aware of how their rental business looks to the IRS. One of the most important considerations is whether or not you are "in business" or are simply a "passive investor".

When examining the idea of owning residential (or commercial) real estate most people hear of the benefits of "passive income". In reality those should be dirty words for a rental property owner. The reason for this is that people who are in a business are taxed differently than those who own rental property passively.

If you are deemed to be a passive investor you get to deduct the normal costs associated with your rental property but cannot deduct additional items related to your home office, for instance. As a passive investor you will also be limited on what you can deduct from any losses you may incur. Passive losses can generally only be deducted from passive income. Presently you're limited to $3000 of passive losses that can be deducted from your other active income (such as your job or other employment).

Business owners, however, can deduct losses incurred from their active business(es) from other sources of income. Here, again, there are certain limits and considerations when it comes to real estate but the point is you should be viewed as an active participant in your rental property enterprises to get the best tax benefits.

Business owners also get to deduct start up expenses and home office deductions as part of their business activities. Again, passive investors cannot.

Having your rental business viewed as an active business vs. a passive activity by the IRS is something of a slippery slope. Very similar looking examples can be found that went both ways when challenged. The best thing we can tell you to do is to keep accurate records, have your property's income and expenses handled from a checking account separate from your personal one, and make sure you are overseeing your property as a business. It's alright to have a property manager (just as it's alright to have a manager work for you in any other business). You really just need to make sure that you have your fingers in all of the aspects of your rental business and that you treat it like what it is - a business.

For greater surety get with your real estate knowledgeable tax planner and go over the way you operate your rentals. This is one area where you definitely need to get things right.

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