The Passive Income and Tax Benefits of Investing in Rental Real Estate
I have always loved the idea of passive income, and investing in rental real estate is one of the best ways to materialize the idea.
Real estate investing is a popular option among inventors looking for relatively more aggressive or alternative investments to the traditional stocks, bonds and CDs.
Investing in rental real estate properties allow owners to benefit from monthly cash flow in form of rent, without necessarily having to perform any additional work. Without going into debate over whether passive income exists, it is because of this that rental real estate is considered an investment that generates passive income.
In addition to passive income, because investing in rental real estate can be a both a passive and active endeavor, an investor can benefit from significant tax deductions from either.
For example, many rental property owners do not live in the rental property, and therefore expenses to maintain the property can be more than rents received, particularly in a struggling economy like we are in today where there could be some vacancy (time the property is unoccupied by a tenant).
When expenses exceed the gross rental income, losses are generated from the investment activity that can be used to offset profits from earned income or income from employment.
There are certain rules and regulations that govern the treatment of rental losses for tax purposes however. These rules are called “at risk” and “passive activity loss” rules which limit the use of rental property investing related losses for any given tax year. Losses resulting from passive activity can only be claimed as deductions to the extent of income from that activity.
The excess losses can be carried forward to the following year or years until used, similar to losses from capital investing wherein you are allowed to deduct $3,000 each year and carry forward the rest. If and when you dispose the underlying asset, in this case the rental real estate, you are entitled to take all of the remaining carry forward loss balance in the year of disposal.
Basically, losses from rental real estate that are limited by passive loss rules are merely delayed and not wasted. You have to be careful and keep track of unused loss deductions as it is easy to forget.
There is an exception to this rule however. If you are actively (not passively) involved in the rental activity, you are then allowed a deduction of up to $25,000 in excess of income generated by the rental activity, phased out for every dollar exceeding $100,000 in adjusted gross income (AGI).
These figure can vary based on the tax law at the moment. But the underlying premise is that if you are actively involved, you can deduct more losses than if you were only passively involved.
Does active mean regularly unclogging the kitchen sink? No. As long as you can prove you were actively involved in the management of the rental property, you should be able to take deductions you are entitled to.
Hope I was able to highlight just some of the benefits of investing in rental real estate. I will be discussing this topic in depth in the coming weeks, focusing on real estate investing from a broader and in-depth perspective.
It is one of my favorite forms of investments as it is one of the best ways to generate passive income, diversify your investment portfolio, build wealth and hedge against inflation all through one investment vehicle.
Readers: Do you have any real estate investments? Are you planning on investing in rental real estate at some point? Why or why not?
Here are my thoughts on value investing in rental real estate, which beats speculation any day in my opinion.
Sunil
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Next: Creating Financial Independence: The Importance of Passive Income
23 Responses to “The Passive Income and Tax Benefits of Investing in Rental Real Estate”
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I have a house that I am renting out. It does not generate positive cash flow every month, but money does go in to the principle. I’m not sure what this is called.
Mortgage is $1,500. $1000 to principle, $500 to interest
Rent is $1,500
Tax is $200
So I net $800 toward principle every month, but I have to kick in $200. This is not positive cash flow right?
I want to get a 4 plex next year if the bank will lend me money.
A bit confused. You are collecting $1,500 in rent, of which $500 goes to tax and $1k to principal. How are you then netting $800 toward the balance? Is that because the 1k includes a $200 escrow payment for tax?
Let’s dissect this further and see where you stand.
If you are breaking even from a rental property, I don’t know how you feel about it but in my opinion you are making money in the following ways:
1) Someone else is paying down your debt, which will end up earning you a property in the long run
2) The property may appreciate, which can be icing on the cake. If it depreciates, as long as your cash flow is positive, you should be ok. Over the long run you will end up owning it without having had to pay for ALL of it (because your tenant is paying down your mortgage)
3) Tax benefits of rental real estate investing that bring you more refund back at year end
4) Over time, as mortgage goes down, your positive flow will increase
Sunil,
I think you misread above.
rental income: $1,500.
expense: total $1,700
mortgage: $1,500. ($1000 to principle AND $500 to interest )
property tax $200
So expense is $1,700. Every month I have -$200 negative cash flow.
Cash flow is just income – expense right?
Money is going toward principle, but this is still not positive cash flow.
thanks
You will have to run the analysis to determine long term bottom line impact. Don’t forget to account for time value of money. In addition, don’t forget that interest and taxes and deductible, so determine the after tax net impact.
Without going into heavy analysis and not knowing the home value, appreciation potential, etc, I would guess that you will do just fine in the long run.
Whether your after tax net return is more or less than other forms of investments available to you, and ones you are comfortable with, only you can answer whether you have the best possible deal in your hands.
Also consider that you can heavily leverage real estate investing. With $X down today, you can start utilizing a property worth $X+$Y
Interesting. I’m currently asking the question on my blog on whether I should buy a second home or not. I need some help, but there were plenty of good things to consider here.
plug your IRA’s, (ie. other investment buckets), don’t buy a 2nd home unless you have piles of money under your matress.
other than not buying a second home unless you can pay cash for it, what are you exactly suggesting Andro?
Romeo,
What are your purchase objectives? Is it cash flow? vacation? long term investing?
What are your alternatives uses of the time and cash?
Hmm. The hard questions. Yeah, I guess we leave these out too often before we jump right into investing, huh?
Well, my objective is to have a home paid in full in nine years prior to retirement. My home in GA is on its way there, but I have no desire to move back there. However, I do desire (at the moment) to live in Charlotte once I retire.
The alternatives? Well, for the next 36 months, I have to live somewhere. I can rent out a nice place for about $1500 a month, or I can find a $150,000 home (at a substantial discount), get a fifteen year fixed rate at 4% and pay the same amount (for the next 36 months).
The root of the dilemma? To shell or not to shell $20,000 cash into the GA home just to sell it off at the current “market value” and give up the roughly $50,000 that I have put in it so far.
Sounds like you are under water 70k? (50k you put in + 20k more you have to pay up). If so, can you rent it out and generate positive cash flow while you either rent or pursue the other home?
I may not be fully understanding the situation. Regardless, the main questions I address when I buy real estate are 1) objective of the purchase 2) alternative options 3) other non quantifiable or intangible aspects such as emotion / sentiment
Hi,
If I turn my rental into a second home and stop renting it completely what happens to all of the passive losses that I have already accumulated?
Linda
What do you mean by “already accumulated”? You should have deducted losses in the year(s) you incurred them, and carried forward the rest and applied it to profitable years. If you remove your property from your business (i.e. rental) and make it a home, I do not believe you can deduct any of the expenses of running/owning/maintaining your home as “business expenses”.
By accumulated I mean the passive losses that are still being carried over. The place has never made a profit and so the losses that are over and above our rental income are being carried over each year and actually accumulating. I know that if it stops being a rental that we cannot claim any expenses of running the place, but I want to know what happens to the passive losses that we still have on the books.
I believe you can write off all the carried over (balance of) losses upon selling the property, however do not quote me on that as I don’t speak from first hand experience . . .
Hey Linda, I think that even if you stop renting out the place as it is not generating positive cash flow, you should evaluate if the rental income from tenants do supplement the mortgage interests (even if it doesn’t cover it entirely, something is better than nothing, unless you have tenants that are trashing your place and causing more cost factors).
The passive losses will remain passive losses on the books regardless of people renting or not, the difference is just how much the passive losses are. Why this occurs is because up till the point your tenants are staying with you, the books will reflect this period as a tenancy period, which will/should go into the books. Perhaps what you need is refinancing options, or consider to up your rent to cover more of the costs etc.
We’ve all heard that investing in Real Estate is a great deal. But to make sure it is indeed, we must first educate ourselves to ensure that the decision is a proper one. For many many the first step is saving enough for the very first down payment on their property. It may take a while to accumulate, but from there, it can be the beginning of a new succesful venture. Real estate investments in definately worth considering as a long term goal. Remember education is the key.
Welcome Francisco. Just like any other endeavor, especially one requiring significant capital outlay, one must be comfortable with the ins and outs before jumping in. In the early 2000s, investors were able to leverage as much as possible by taking out 0 down loans. Those days are gone, at least in the current and near future.
Pretty nice post. I just stumbled upon your blog and wished to say that I’ve really enjoyed browsing your blog posts. After all I will be subscribing to your rss feed and I hope you write again soon!
welcome Alberta
Sunil:
I am investing in real estate with partners. What tax advantage can I get as a passive or active investor?
as an active investor you have all the advantages of running a business (expense deductibility). as a passive investor, these deductions are limited but then you are also less involved. both are better than not investing at all.
real estate is always and will always be the best source
of generating income. the thing is that the paper works is quite enormous, you need to do deed of sale, deed of transfer.
then some insurance, then tax afterwards.
setting up any passive income stream involves work. but once you have put in the work, things get significantly easier over time afterwards don’t you think so? what are you working on or what do you have going on these days?