Real Estate Investing
Your Guide To Earning Passive Income On A Rental Property
Belong on Mar 31, 2022
At Belong, we get a lot of questions about how you can generate passive income from a rental property. People want to know if real estate is a good passive investment; how they can make money passively in real estate; and what the tax rate is on passive rental income. The questions eventually ladder up to, “How can I make $1,000 a month passively in real estate” – or, if you’re talking to someone who’s really ambitious, “Can owning rental properties make me rich?”
That people have these questions makes sense to us, for two reasons:
Reason One: If the income generated from your rental property qualifies as passive, you don’t have to pay as much tax on it. And who doesn’t want to make more money by doing less work?
Reason Two: The answers to these questions can, at times, be hopelessly convoluted. So even if someone’s told you a thousand times how to calculate the tax rate on passively earned income from a rental property, unless you’re an accountant, you probably still aren’t sure.
When it comes to questions relating to tax code, we always recommend that you consult with your lawyer or accountant: nonetheless, we’ll do our best to answer that question – and the other ones listed above.
But first, before we drill down into the nitty-gritty, let’s start with the basic question: how do you define passive income?
Defining passive income
Passive Income is defined as income generated from an enterprise in which you are not actively involved. That can be a limited partnership, or a business in which you are a silent investor or partner, or a rental property.
It’s important to keep in mind though that property may or may not qualify as passive income – and the distinction between passive and active may not be what you think. It’s a complex subject, if not somewhat of a minefield. Because the way the IRS views passive is not that black-and-white, we urge you to learn the basics – knowledge is power – and speak with a tax advisor.
In fact, there are specific criteria for what constitutes “passive” income, and significant tax implications as well. In what follows we provide a “summary” of what passive income means (and please note that is a big set of quotation marks around the word!).
Investopedia is a reliable source of insights on this subject; they identify three broad categories of income: active, passive, and portfolio. This goes beyond real estate, but to drill down there, they write that: “Passive income is earnings derived from a rental property, limited partnership, or another enterprise in which a person is not actively involved. As with active income, passive income is usually taxable, but it is often treated differently by the IRS.”
So if you own a rental property, does that mean your income automatically qualifies as passive, and you benefit from any tax implications of that classification? Not necessarily. If you are a real estate professional, your income is not passive. If you aren’t a real estate professional, but end up doing the work of one – if, for example, you act as a broker for the property – the income is no longer passive. Further, if the IRS deems you as “materially participating” in the management of a property, the income will typically not qualify as passive.
While the below is not exhaustive – here is a link to the material participation test – if you don’t meet these standards, chances are your income is NOT passive; note that number three is a criterion which involves not just your role, but how it compares to the roles others might be playing in the process. In other words, the 500-hour rule may not apply if there is no one contributing more hours than you are.
- If you’ve dedicated more than 500 hours to a business or activity from which you’re profiting
- If your participation in an activity has been “substantially all” of the participation for that tax year
- If you’ve participated up to 100 hours and that is at least as much as any other person involved in the activity
If it turns out your income is indeed passive – and you have losses - there are specific passive activity rules that you need to be aware of.
The reason it’s so important to understand the details of passive income is that anyone who owns a property – or is considering buying one – might underestimate the amount of time they need to spend managing property. Which means their tax situation can creep from passive to active before they know it.
That’s why we urge you to speak with an accountant, tax planner, or financial advisor to determine whether your current – or projected future behavior – would characterize your rental income as passive or active.
Why invest in passive income opportunities?
Now that we’ve covered some of the basics of what qualifies as passive income, you may be wondering if direct investment in residential real estate is the best way for you to participate in what has historically been one of the most reliable asset classes.
Here’s an article from Forbes – one of many on the subject – which is headlined “Why Real Estate Builds Wealth More Consistently Than Other Asset Classes.” And here’s an article from Business Insider about a young entrepreneur who made strategic passive investments. Note that he hired a property manager so this wouldn’t become “his job.”
If you already own residential property – whether you’ve owned it for a while, bought it for investment, or inherited it – then you will need to determine if you meet the standards for passive income we discussed, or whether you want to hire a property manager (we’ll get to what that entails and why Belong is playing that role for so many enlightened homeowners). Or, of course, you can decide you don’t want to remain an investor in real estate, sell the property for profit, and invest the proceeds in another asset class.
Other ways to achieve passive real estate income
Direct ownership of real estate is just one of many ways to invest in that asset class. Recently there has been a great deal of “fintech” innovation which enables you to buy fractional ownership in residential or commercial properties. Examples of these platforms that seek to “democratize” real estate investing include Fundrise; here’s a link to Investopedia’s best crowdfunding sites of 2022. In addition to taking none of your time, and being able to step in for as little as $10 – and invest more at your discretion – these platforms also provide the value of diversifying your risk across multiple properties.
REITs – or real estate investment trusts – are another passive investment opportunity which some prefer to crowdfunding. Here’s a useful article from Seeking Alpha which lays out the reasons why so many investors find REITs to be an attractive opportunity.
Either way, we urge you to do your due diligence; there are no guarantees and as this piece elucidates, there are inherent, structural issues with crowdfunding platforms which are worthy of your consideration and attention.
Next up in our passive income journey: some important information about the role property management can play.
Does passive income live up to its name?
If you’ve made it this far, no doubt you’ve discerned that “passive” income isn’t necessarily all that passive, according to both the dictionary definition of the word, and according to the IRS’ definition.
Even if the income is generated through a REIT or a crowdfunded real estate investment, a lot of work goes into the decision making process; you have to research the sector the REIT focused on, and also (of course) the REIT itself its past performance and its ratings according to sites like Morningstar and MarketWatch. It’s also important to read any relevant analysis available through Motley Fool and Seeking Alpha.
The more you read about the REITs in general – and the specific REITs you’re thinking about investing in – the more insight you’ll get into other key indicators you should be looking at. Triple net leases, for example, speak to the stability of the rental flow – and, by extension, the stability of the REIT itself. Occupancy rates are another indicator that speaks to the stability of a REIT. This article in Forbes by REIT expert Brad Thomas will provide you with some insight into what he looks at before he invests.
For those of you who are looking to invest in a rental property (which, given the nature of Belong, is probably most of you), preliminary work will involve a geographic and demographic analysis of the city or town and the neighborhood you’re looking to invest in, along with a thorough examination of the rental markets in those areas, in order to determine whether there is enough demand to safely enter the marketplace. We’ll do a deeper dive into this process in the next section, but needless to say it’s one of those things that’s easier said than done.
After you’ve purchased the home, prepared it for the marketplace, and found someone to occupy it, you have to take care of all the problems, big and small, that crop up with the property. Which, as we’ve discussed many times elsewhere on this blog, consumes a huge amount of time and energy. Complicating the situation is the fact that you can only spend so much time on the task if you want the income to qualify as passive: in case you need a refresher re-read the previous section for more information on the 500-hour rule.
Is being a landlord a good source of passive income?
It can be.
At Belong we pride ourselves on transparency and honesty, so we won’t pussyfoot around the fact that there are other forms of passive income that can indeed be more profitable. Dividends from a stock investment, for example. Or if you’re a silent investor in a company that takes off and transforms into an Uber-sized unicorn.
But unicorns are called that because they are one in a million – or even one in a billion, if you take into account the number of start-ups that barely get off the ground.
Investing in a rental property might not be as sexy as being an angel investor in some hot new idea, but it’s far less risky, if done properly. Plus, even if the yearly returns are more modest, you get to participate in the appreciation accrued by the property, if and when you decide to sell it down the line.
All this means that the research you’re doing at this stage is that much more important. You want to make sure that the property you’re looking at is in a strong, growing market: not only will that help you maximize the money you make from renting it, but also it means that, when you eventually sell the place, the investment will have gone up that much more.
Also keep in mind that unless you work with a property manager the income you generate from your rental property probably won’t even qualify as passive. So in addition to having to deal with the time and energy-sucking elements of life as a landlord, you don’t get to participate in a big part of the upside!
How much money can I make from a rental property?
This is a difficult question to answer, as it involves a lot of contingencies we can’t really account for. For example, where in the world is the rental property in question? Obviously if you have two-bedroom apartment in the middle of Silverlake you can charge a lot more rent than if you have a studio apartment in Pomona. You don’t need to be a tax attorney or an accountant to figure out that you stand to make a lot more money for the two-bedroom apartment in the more desirable part of the world.
On the other hand, you probably do need to be a tax attorney or an accountant to figure out how to calculate the taxes you need to pay on the income generated from either of these properties. The IRS allows people who own rental properties to deduct the amount of depreciation that occurs to the home on a yearly basis: the laws are fairly convoluted, and we advise you talk to a professional in order to gain a better grasp on this material, but the basic gist of it is that you are able to deduct a certain amount of money based on the amount that you paid for the property itself on a yearly basis. You are also able to take deductions based on expenses the IRS deems “ordinary and necessary:” for example, money spent on repairs and utilities and homeowner’s insurance is deductible.
There’s a baseline amount of depreciation that occurs on a yearly basis for the first 27.5 years that you own a rental property. Again, we strongly encourage you to consult with a professional, but the way to calculate this number is by subtracting the cost of the land that the property is on from the amount that was spent on the property itself, and dividing that number by 27.5: that number is the baseline amount you can deduct on a yearly basis to account for depreciation. That number can be supplemented by money spent on upkeep and improvements to the property, which includes anything from structural improvements to landscaping costs.
The more you’re able to deduct, the less tax you have to pay – and the more money you can make from your rental property.
Property managers can help ensure income remains passive
The only situation in which you can actually sit back, relax, and cash the checks that will come rolling in is if you work with a property management company. It’s also the easiest and cleanest way to ensure the income remains passive in the eyes of the government. By putting the responsibility of managing the day-to-day operations in the hands of a property manager you are guaranteeing that someone other than yourself will be taking on the lion share of the work.
In short, if your property manager is actually doing their job, there’s little to no chance that you will dedicate 500 hours in any given year to the task of managing the property yourself.
A property manager will take most of the major time-killing responsibilities of owning a rental property off your plate: they will prepare the home for the market, stage it, photograph it, list it, show it, perform background checks on each and every applicant, and draw up the lease agreement. Then they will take care of any maintenance request that emerges over the course of the lease. They also take care of collecting rent, and if worse comes to worst, they will handle the eviction process.
For all these services property managers will charge you 5-10% of the rent on average. Beware though that many property managers — even the reputable ones — will find ways to nickel and dime you. They might upcharge for taking photographs of the place, or for creating the kinds of videos and 3D tours that have become commonplace in the age of COVID; they’ll take money off the top when you have to pay a contractor; and if they do have to evict someone, there’s often a fee associated with that, too. That’s why it’s critical to do your research before hiring a property manager; make sure to interview them, and know what questions to ask.
As a corrective to these opaque and retrograde business practices, which for years have been the industry standard, there’s Belong. Belong combines the best technology with the kind of seamless, concierge-style service that guarantees your passivity in both the legal and the colloquial sense. And their fee structure is fair and transparent: there are no upcharges or hidden fees, and because they employ their own teams of contractors and craftsmen (Belong Pros), there’s no motivation to overcharge you for those services, either.
While it’s possible to hire a property manager for some services, and do the rest yourself, it’s hard to assure that the hybrid model keeps you within the IRS framework for passive income. Without employing a property manager it’s likely that your investment will fail to qualify as “passive”. It’s a damned-if-you-do, damned-if-you-don’t-Belong type situation.
Passive income and the accidental homeowner
There is no solid data for the number of “Accidental Homeowners” in America – those who inherit houses and suddenly must assume the full range of responsibilities that are triggered by that unexpected obligation, the complexities (and opportunities) of owning and managing a home to potentially generate passive income. (Here we’re assuming the accidental homeowner doesn’t choose to move into the home they’ve come into possession of.)
Given the inevitable wealth transfer as the Baby Boomer generation shuffles off this mortal coil and Gen Z and Millennials inherit their assets (estimated to be in the trillions), there’s no doubt the number of Accidental Homeowners could be in the hundreds of thousands.
If you count yourself among them, before you even get into the process of deciding whether to “keep or sell” the property, the first step you’ll need to take inN handling the basics, which includes things like dealing with the underlying will, the role, if any, of probate, the transferring of title, and so on. Some of this will be done in collaboration with the executor, if there is one. It can get complex even without the added emotional complications of going through the grieving process, so it’s important to have an experienced lawyer at your side.
Once you work through the transitional details you will need to determine what your ultimate plan will be. That will likely depend on whether you need to pay any estate tax on the house; that will influence your “steady state” financial situation going forward.
Eventually, when the financial puts and takes of your new ownership are worked through, you will have three basic options:
1. Move into the house
You might have an emotional connection to the property that you want to perpetuate, and you could be at a point in your life where moving into the home is a desirable lifestyle transition. Of course, you will need to assess the carrying costs – a mortgage, if there is one – along with taxes, utilities, and maintenance. If you inherited some capital along with a house, that could alleviate any cash flow pressures. Regardless though you’ll need a good accountant to help you conduct the analysis.
2. Sell the house
It might be a wrenching emotional decision, but it could be the right one. Homeownership is complex and stressful, emotionally and financially. Regardless of whether or not there is a mortgage you need to pay off, you might want to use the proceeds of the sale to start a business, or simply to invest in another asset class that doesn’t require any attention.
3. Rent the house
This brings us back around to the subject of passive income, which has been the focus of this primer. The advantage of keeping and renting the house is not just the passive income you might be able to generate, but that you preserve your ability to move into the home at some point in the future. Plus, you can take advantage of any appreciation in the home’s value.
You will, of course, need to decide if you want to manage the property yourself – which could be a burden if it’s not located nearby, and if you have little or no experience as an owner. In which case, you should consider a property manager. Belong is the modern, 21st-century property manager who simplifies, streamlines, and organizes the rental experience for all homeowners, including those who have come into this situation “accidentally.”
Mistakes to avoid when trying to generate passive income through a rental property
So you’ve read this article and concluded that you’re in: owning a rental property seems easy enough, and you want to have a consistent, safe source of passive income coming in. Great.
But before you go off half-cocked trying to buy a house to rent out, we implore you to read the following list of common errors we’ve seen homeowners make time and again.
The best way to ensure a steady flow of rent checks is to buy a home in an area where the rental market is thriving – and will continue to thrive. Not only that, you want to do your best to ensure that you make as much money as possible if and when you sell the property down the line. Which means you need to do your homework and invest in the right part of the world. The best place to invest is one that’s still on the come-up – meaning, the prices are on the rise but they haven’t maxed out. So there’s room for your investment to grow.
It’s a balancing act, though: you don’t want to invest in an area where the rental market is immature – where you won’t be able to realize a great return on the investment, either. That’s why we recommend doing a deep dive on any neighborhood before you even start to look at properties.
Not being liquid enough:
As the old cliché goes, it often takes money to make money. This is definitely true of becoming a landlord. The rewards are great, but before you realize them, you will have to invest a lot of resources into the property itself. And you can’t always know how much money you’ll end up needing to invest. As anyone who’s owned a rental property will tell you, you must expect the unexpected. The water heater might blow a gasket, or an extended family of rodents might decide to take up residence in the basement. Or it may turn out that there’s a radon problem that requires the installation of pricey abatement system. To have success as a landlord you need cash on hand to cover these unexpected costs.
Assuming it will be easy:
Even in the best of circumstances owning a rental property takes a lot of time. If all you have to do is make sure that the rent checks are collected every month, that requires effort and follow through. And that is never all you have to do. Like we said above – expect the unexpected.
Another title we could have used for this section is make sure you have enough time to actually be a landlord. And if you don’t – hire a property manager like Belong.
How Belong can help make passive income truly passive
The idea of generating passive income from a real estate investment is certainly attractive, but you need to keep in mind the thin line the government’s drawn between “passive” income and “active” income in order to ensure you don’t accidentally cross it.
For people who are considering purchasing a rental property as an investment – or for those accidental homeowners who’ve inherited a home and are now deciding what to do with it – the best way to ensure that the income garnered from your investment remains passive is to hire a property manager. In fact, considering how much time being a landlord takes, it might be the only way to safely avoid violating the 500-hour rule.
Whether or not it’s worth it depends on how much your property manager will charge you, how much income you can generate through the property, and how much money you’ll save come tax time if that income qualifies as passive, rather than active. To make that determination you should discuss the matter with an accountant, who can help walk you through the math, and also discuss the tax implications.
If you do decide to employ a property manager, it’s important to have a crystal-clear sense of how much they’ll end up charging you. That’s why it’s critical that you ask the right questions when you’re researching and interviewing property managers. There are often a lot of hidden fees and up-charges that sneak up on you and affect your bottom line, and transparency is not a quality that most property managers possess.
In that regard Belong is an outlier in the industry. The things other property managers will charge you for Belong offers free; and because they employ their own contractors and craftsmen full-time, there are no mark-ups when it comes to repairs and renovations. (And you can rest assured that the work is being done quickly and to the highest standards, because Belong Pros are carefully vetted, and work exclusively on Belong properties.)
Curious to know if your home might belong on Belong? Click here to see if it qualifies.