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You are here: Home > I Just Got a Rental, What Do I Do? > Chap 3 - Rental Property Tax Considerations > Three Types of Income

  • I Just Got a Rental, What Do I Do?

    • Introduction

      • About the Author
      • Progressive Updates
      • Introduction Disclaimer
      • Shameless Self-Promotion
      • Book Introduction
      • Quick Reference 2023
      • Quick Reference 2024
      • Glossary
    • Chap 1 - Ownership Arrangements

      • Real Estate and Rental Properties as a Business
      • Basic Business Entities For Real Estate Investment
      • Sole Proprietorship
      • Single-Member Limited Liability Company (SMLLC)
      • Multi-Member Limited Liability Company (MMLLC)
      • Limited Liability Partnerships (LLP) and General Partnerships (GP)
      • Rental Property In Partnership Entities
      • C Corporations
      • Rental Property In C Corporations
      • S Corporations
      • Pass-Through Versus Disregarded Entity Taxation
      • Your Spouse As A Business Partner (Happy Happy Joy Joy)
      • Owning A Rental Property With Others
      • Real Estate Investing With Family Partners
      • Real Estate Holding Company and Operating Company
      • Pure LLC Holding Company
      • Economic versus Equity Interests
      • Structuring Real Estate Deals with Angel Investors
      • Loans or Capital Injections
      • LLC Benefits For Rental Properties
      • Multi-Entity Rental Property Tiered Structure
      • Using a Trust In Your Real Estate Holding Company
      • Operating Agreements For Real Estate Partnerships
      • Real Estate Succession Planning
      • Fallacy Of A Nevada LLC (or Delaware, or Wyoming, or wherever!)
      • Liability Protection Fallacy Of An LLC
      • Charging Orders
      • Using A Self-Directed IRA Or 401k To Buy A Rental Property
      • Trapped Rental Assets In An S Corporation
    • Chap 2 - Initial Asset Management

      • Getting The Rental Business Launched
      • Rental Property Acquisition Costs
      • Real Estate Asset Setup On Your Tax Returns
      • Cost Segregation Study
      • Retroactive Look-Back Cost Segregation Study
      • Converting Primary Residence To A Rental
      • Moving Your Rental Property Into An LLC
    • Chap 3 - Rental Property Tax Considerations

      • Three Types of Income
      • Passive Activity Loss Limits
      • Passive Income Generators (PIG)
      • Your Small Business As A Passive Income Activity
      • Material Participation Rules
      • What Time Counts For Material Participation
      • Real Estate Professional Status (REPS)
      • Short-Term Rental (STR) Loophole
      • Vacation Home Rules
      • State Problems With Your Rental Property
    • Chap 4 - Rental Property Tax Deductions

      • Chapter Introduction
      • Five Basics to Warm Up To
      • Value of a Rental Property Tax Deduction
      • Rental Property Tax Deductions Themes
      • Section 199A Rental Property Deduction
      • Common Rental Property Tax Deductions
      • Allocation of General Rental Expenses
      • Rental Property Travel Deductions
      • Rental Property Meals
      • Mortgage Interest Tracing
      • Acquisition Costs (revisited)
      • Rental Property Repairs Safe Harbor (revisited)
      • Repairs Versus Improvements (revisited)
      • Rental Property Depreciation (revisited)
      • Automobile Deductions with Rentals
      • Automobile Decision Tree
      • Home Office Deduction
      • Real Estate Education Expenses
      • 185 Rental Property Tax Deductions You Cannot Take
      • Deductions the IRS Cannot Stand
      • Cohan Rule For Rental Property Owners
      • Reducing Taxes
    • Chap 5 - Operational Asset Management

      • Rental Property Repairs Safe Harbors
      • Improvement Versus Repairs
      • Rental Property Renovations (Rehab)
      • Accelerated Depreciation and Section 179 Deduction
      • Allowed Versus Allowable Depreciation
      • Qualified Improvement Property (QIP)
      • Partial Asset Disposition (PAD)
      • 1031 Like-Kind Exchange
      • Selling Your Rental Property
      • Buying Out Your Real Estate Partner
      • Taking The Rental Out of Service
      • Changing Depreciation Between 27.5 and 39.0 Years
    • Chap 6 - Retirement Planning

      • Retirement Planning Within Your Rental Property
      • Basic Retirement Planning
      • Tax Savings and Tax Deferrals
      • The Owners-Only 401k Plan
      • Roth 401k Plans
      • Roth 401k Versus Traditional 401k Considerations
      • Two 401k Plans
      • Rolling Old 401k Plans or IRAs into Your Small Business 401k Plan
    • Epilogue

      • Rental Property Tax Return Preparation
      • Rental Property Accounting
      • Real Estate CPAs
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  • I Just Got a Rental, What Do I Do?
  • Chap 3 - Rental Property Tax Considerations
  • Three Types of Income
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Three Types of Income

types of incomeBy Jason Watson, CPA
Posted Saturday, August 10 2024

Let’s back up a bit. Our book loves to spill the beans so-to-speak with the net-net fun facts, and then dig a hole under the house for the foundation. Wow. All kinds of metaphors. There are three types of income- earned, portfolio and passive.

Earned Income

Earned income is income that is a direct result of your labor. This income is usually in the form of W-2 wages or as small business income reported on Schedule C of your individual tax return (Form 1040). Both are subject to Social Security and Medicare taxes (self-employment taxes). There are other areas such as Schedule E or F where income can come into your individual tax return and be subject to self-employment taxes, but Schedule C is the most common.

Portfolio Income

Portfolio income is income generated from selling an asset, and if you sell that asset for a higher price than what you paid for it originally, you will have a gain. Depending on the holding period of the asset, and other factors, that gain might be taxed at ordinary income tax rates or capital gains tax rates. Interest and dividends are other examples of portfolio income.

Capital gains are not a form of income per se. Capital gains simply defines how your portfolio income will be taxed. Income is income, and is therefore taxed. This income might be taxed at capital gains rates or ordinary rates. Subtle difference.

Portfolio income is not subjected to self-employment taxes, but it might be subjected to net investment income tax (NIIT). See our section on real estate professional status (REPS) which side-steps NIIT.

Passive Income

We touched on this in a previous section. Passive income bluntly is income that would continue to generate if you died. Morbid. How about this? Passive income is income that would continue to generate if you decided to do nothing and sunbathe on some beach. That sounds better. Passive income includes rental property income and royalties, and income from businesses or investment partnerships / multi-member LLCs where you do not materially participate.

Passive income is also not subject to self-employment taxes but similar to portfolio income, it might be subject to the Net Investment Income Tax (NIIT). So, if you own a rental property, the net income (profit) generated from the activity is considered passive income although your participation might be considered active. If you take this same rental activity and provide certain services such as tours, your income might be considered earned income and subject to self-employment taxes.

Additionally, if you wrote a book and receive royalty checks, that income is also passive and not subjected to self-employment taxes. However, if you write several books or make updates to an existing book (like this one) then you are materially participating in your activity and your income is earned income. And Yes, you would pay self-employment taxes on that income.

You might also intentionally want passive income to offset or absorb your passive losses. We talk about passive income generators (PIGs) in a later section. No, you cannot manufacture passive income to allow passive losses to be deducted with self-rentals.

Self-Rentals

It is common for a business owner who relies on machinery or equipment, including real estate such as an office building, to have two business entities. One entity is an LLC that owns the assets. The other entity is an S corporation which leases the assets from the LLC for use in the business.

Treasury Regulations Section 1.469-2 boringly reads-

(f)(6) Property rented to a non-passive activity. An amount of the taxpayer’s gross rental activity income for the taxable year from an item of property equal to the net rental activity income for the year from that item of property is treated as not from a passive activity if the property-

(i) Is rented for use in a trade or business activity (within the meaning of paragraph (e)(2) of this section) in which the taxpayer materially participates (within the meaning of Section 1.469-5T) for the taxable year; and

(ii) Is not described in Section 1.469-2T(f)(5).

Read that first paragraph again. The phrase “treated as not from a passive activity” tends to stand out. This essentially means you cannot use a self-rental to generate a bunch of passive income to offset your otherwise non-deductible passive losses.

Jason Watson, CPA, is a Senior Partner of WCG CPAs & Advisors, a boutique yet progressive tax,
accounting and business consultation firm located in Colorado serving real estate investors worldwide.


Jason Watson CPA LinkedIn     Jason Watson CPA Email

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I Just Got A Rental, What Do I Do? 2024-2025 Edition

This KB article is an excerpt from our 320+ page book (some picture pages, but no scatch and sniff) which was released September 30, 2024, and is available in paperback from Amazon, as an eBook for Kindle and as a PDF from ClickBank. We used to publish with iTunes and Nook, but keeping up with two different formats was brutal. You can cruise through these KB articles online, click on the fancy buttons below or visit our webpage which provides more information.

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