Passive income as a landlord is a myth and …. you probably shouldn’t be chasing it anyway. Whether you still think passive income is the goal or are wondering *what exactly * is passive in real estate after diving into it, this episode is for you!
IN THIS EPISODE, YOU’LL LEARN:
- Why passive income is a deceptive term
- The 3 types of taxable income & the MAJOR tax benefit of being an active landlord
- The sweet spot between active and passive landlording
If you’d like a shoutout (and a chance to win a $20 Home Depot gift card), just leave a review on Apple Podcasts and send a screenshot of it to me on Instagram via DMs!
Why passive income is a deceptive term
Real estate “passive income” is often used as a marketing strategy to attract people looking for an alternative to their regular jobs. Podcasters, social media influencers, and course sellers promote it, but being a landlord requires a lot of tasks and responsibilities. Many who claim to offer passive income oversimplify the reality. While investing as a limited partner in a syndication can be more hands-off, it’s not comparable to being an active landlord.
The idea of passive income in real estate may not match the expectations set by influencers and course sellers. Being a landlord involves significant work and expertise.
The 3 types of taxable income & the MAJOR tax benefit of being an active landlord
Passive income gained popularity due to the tax benefits it offers compared to earned income. Earned income, such as wages or business income, is subject to high taxes. In contrast, passive income from rental real estate, limited partnerships, and royalties can have lower effective tax rates due to depreciation and amortization deductions.
The IRS generally considers real estate rental activities as passive, meaning losses from these activities cannot be offset against active income. But, if you qualify for Real Estate Professional Status (REPS), you can use depreciation losses from your real estate investments to offset your highly taxed professional income.
To claim REPS, you need to meet certain requirements:
- 750-Hour Rule: You must spend at least 750 hours on real estate activities that are considered work activities, not just investment activities, which include:
- Greater Than Half of Professional Time Rule: Real estate must be your main focus, and you should spend more time on real estate than any other profession or activity.
- Material Participation: You must materially participate in each real estate activity on a regular, continuous, and substantial basis. Hiring a property manager for most of your properties may not count, and short-term stays may have different rules.
You can group your activities under a “grouping election,” but the rules still apply to the entire group. It’s important to note that if you operate like a hotel with stays under 7 days, you may be exempt from certain requirements but still need to materially participate.
In summary, passive income in real estate offers tax advantages, especially when you qualify for Real Estate Professional Status. However, specific criteria and active involvement in real estate activities are necessary to claim these benefits.
The sweet spot between active and passive landlording
Leveraged income is really what we want. WE want our businesses to work smarter for us. There is no prize for martyrdom. For working harder than you have to in your rental business not thinking about your business as a business.
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Bonnie Galam 0:00
Hey it’s bonnie and I’m back to go on what is perhaps a stereotypical Bonnie rant about an industry term that I feel is beyond gross and misleading and that’s the term “passive income.”
I got a little fired up recording this episode so As a little warning, I use a some light spicy language so if you’re listening in the car with the kiddos around then maybe pop the headphones in or save this for later. My kids are like curseword narcs and their threshold is low. They will tattle on each other for saying “shoot” and “stupid” which is both adorable and little much. But I’m highly cognizant of the words coming out of my mouth these days and caught some PG-13 language that I figured was worth the disclaimer.
As I’m sitting down to record this at the start of the month, when the rent comes flowing in and the instagram posts of “Rents Due” flood my feed and wanna be investors start foaming at the mouth at what could be. And existing landlords are letting out a small sigh of relief as the payments come in. And I don’t know about you but I’ve never not once felt like I did no work to deserve that rent coming in.
And to be honest, the more we flout that attitude the more people come back at us as slumlords who don’t do anything and heartlessly profit off of other’s people’s poverty
From a PR perspective We can’t have it both ways.
So stick around because this episode is for you if you’ve been chasing passive income and are now having an existential crisis thinking – bonnie wtf are you talking about. The whole point i’m doing rentals is the passive income.
The episode is also for the investors who are at the other end of the spectrum thinking there’s not a single part of this that feels passive because at the end of the episode I’ll go into the sweet spot between active as passive that we landlords should be targeting.
Now without further ado let’s get into it
Why passive income is a deceptive term
IT’s used as essentially a marketing ploy to get people started in real estate investing. ThInk about who uses it the most. Probably podcasters and social media talking heads who want to sell you some intro course into investing. Passive income isn’t quite the far fetched pitch of becoming a millionaire in 90 days but it’s still sexy as all hell for anyone feeling something close to miserable at their w2 job.
However if I was to create a job description for a landlord, the laundry list of tasks that we do – or should be doing – is long. Searching for properties, putting out offers, negotiating offers, managing transactions, applying for financing, evaluating types of financing, budgeting for rehabs, hiring contractors, overseeing rehabs, and y’all we are just at like the 1st R of the BRRRR process. Any one selling you passive income is selling you a load of bullshit in my opinion. The fine print exception being something like an LP in a syndication but I roll my eyes at anyone consiering themselves a landlord if they’re just an LP.
Ok let me digress here for a second for all those instagramers who have like 12,000 units under management or 50mm apartment portfolio in their bio. They wouldn’t know what to do if a tenant died in a unit or the security deposit return process. So sorry no you’re not a landlord. You basically own a stock. Which is fine from an investment standpoint but you can’t even compare the returns or the invovlvement and know how.
Difference between passive in terms of time and passive in terms of taxation.
The 3 types of taxable income & the MAJOR tax benefit of being an active landlord
I think the reason passive income even got started as standard lingo in our Tax benefits of being an active investor. Namely
Earned income consists of income you earn while you are working a full-time job or running a business. Note that “running a business” does not include a rental real estate business in most cases. Earned income will always be subject to high taxes.
Passive income is income earned from rents, royalties, and stakes in limited partnerships. Passive income, from rental real estate, is not subject to high effective tax rates. Income from rental real estate is sheltered by depreciation and amortization and results in a much lower effective tax rate.
Portfolio income is income from dividends, interest, and capital gains from stock sales.
The general presumption by the IRS is that real estate rental activities are passive, and passive losses cannot be used against active income, i.e. the income from your W-2 job. However, if you (or your spouse if you file jointly) qualify for Real Estate Professional Status (REPS), you could use depreciation losses from your real estate investments against your normally highly taxed professional income, reducing your taxes dramatically—potentially even to $0.
There are three main requirements to claim REPS.
1. 750-Hour Rule
2.Greater Than Half of Professional Time Rule
3. Material Participation
750 Hr Rule
What do all those things have in common? They’re WORK activities, not INVESTMENT activities. On the other hand, the activities you may think of when you think of real estate investing, including:
#2 Greater Than Half of Professional Time Rule
The IRS doesn’t want real estate to be your side gig. It has to be your main gig. You have to spend at least 750 hours doing this, and you also can’t spend more time doing anything else than you do real estate. The IRS doesn’t want real estate to be your side gig. It has to be your main gig. You have to spend at least 750 hours doing this, and you also can’t spend more time doing anything else than you do real estate.
#3 Material Participation
Finally you have to actually materially participate in each real estate “activity”, i.e. business or property. Did you get that? You must qualify as “materially participating” for each property or activity where you’re trying to use depreciation losses against your active income.
To qualify as materially participating, your activity must be on a “regular, continuous, and substantial basis.”
If you hired a property manager for 5 of your 7 rental properties, those 5 probably aren’t going to count.
You are allowed to combine all of your properties/activities using a “grouping election,” but then the rules below must still be applied to the entire group of activities. The long and short of hwich is that for stays under 7 days youre acting more like a hotel than a housing provider. SO If that’s what you’re doing, you’re exempt from the 750-hour rule and the half of professional time rule. You still have to materially participate though.
3. The sweet spot between active and passive landlording
Leveraged income is really what we want. WE want our businesses to work smarter for us. There is no prize for martyrdom. For working harder than you have to in your rental business
not thinking about your business as a business.
DISCLAIMER: Although Bonnie is an attorney she doesn’t give legal advice without a written and dually signed engagement agreement. All episodes of the Good Bones Podcast are educational and informational only. The information discussed here isn’t legal advice and isn’t intended to be. The information you listen to here isn’t a substitute for seeking legal advice from your own attorney
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