Is Your Passive Real Estate Income Really Passive?

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If you’ve got a lot of different activities going on, it’s often better to use multiple business structures, to take advantage of differing tax benefits. This advice applies to those of you working in real estate especially. You already know that not every investment is the same. Sometimes you pick up a property with the intention of turning it around fairly quickly, while other times you invest in a property with the intent of hanging onto it for several years.

From a tax perspective, both of those goals can be accomplished – but not in the same business structure.

Any time that you are actively working on a property – fixing it up, managing it, maintaining the property, etc., the IRS looks at the income you make as active, or earned, income. This income is taxed the same way as a salary would be. That makes operating through an LLC unsuitable, as all active income in an LLC is subject to a 15.3% self-employment tax in addition to regular income tax. You’d get a better tax deal operating through an S Corporation, or having your LLC taxed as an S Corporation, so you could split your income and avoid the self-employment tax hit on at least half of your profits.

However, when you pick up a property as a rental and don’t do anything beyond receiving a check from the tenants once a month, the income you earn there is treated as passive income (the best kind!). If you operated a rental property through an S Corporation, or an LLC taxed like an S Corporation though, you would now lose out on some tax benefits. That’s because the S Corporation requires you to take a salary (with resulting payroll taxes) on at least part of your income. Where passive income is concerned an LLC is a great choice, because passive income isn’t subject to self-employment tax at all.

It’s important to understand what you can and can’t do when it comes to passive income. That’s the lesson that Company A learned the hard way.

Company A owns, leases and manages several properties through a mix of independent contractors and full-time employees. It’s a full service company, providing maintenance of common areas and facilities (pool, recreation building, picnic area, game courts, laundry) and looking after lighting, landscaping, trash removal, insect and rodent control, amongst other things. The Company also assists tenants in applying for rental assistance and in cleaning up and repairing storm damage and its employees are on call 24 hours a day for emergencies.

Aside from the active management activities, Company A also looks after the administrative side of property ownership such as maintaining the overall structure including water and sewer pipes, processing tenant applications, and all of the accounting that goes along with the entire operation.

Company A’s problem arose when it tried to declare all of the rental income it earned as passive investment income, in an attempt (presumably) to fail the S Corporation test and be reclassified as a C Corporation. The IRS provides that an S Corporation automatically switches over in the event certain things happen, including when 25% or more of the S Corporation’s revenues come from passive income. (Why Company A was trying to do this, I don’t know).

However, the IRS disagreed. For rental income to be considered passive under IRS regulations, it must be generated without the property owner making much effort or incurring significant expenses to create that income. In Company A’s case, the fact that it was so hands-on with its property management activities made it clear that, in this case, the income that was being earned came from an exchange of rent money for management services provided. The Tax Court agreed with the IRS.

I think a good way to avoid confusion in this case would have been to have the property owned by an LLC, and managed by a separate corporation. That way the division of activities and income would have been clear, and the tax benefits would have been maximized.

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