If you hire a property management company for a rental, does the rental income become a "passive" investment?

Question

I am considering hiring a property management company for a rental but I've heard that, in doing so, the rental income will be classified as a passive investment for me. My worry is that I would not be able to write major expenses (roof, plumbing, etc.) off of my other, non real estate, income, should this happen. Does anyone have insight into this?

Jon Holdman · Answer

First, good rentals don't produce losses, even with depreciation.  This whole "tax advantage" business is lipstick that gets put on crappy deals to make them more attractive.

That 750 hours is the minimum.   If you have a full time job (2080 hours per year) you have to work on RE 2081 hours to be a RE professional.  That's sometimes confusing.

AFAIK, using a PM has no effect on taxes.  You're still actively involved in decision making about the property.

Justin B. · Answer

There are items around being a "Real Estate Professional" that allows you to do things that non professional's can't do and I think the other posters covered that, but one thing I can say for sure is that using or not using a PM won't effect how expenses on your property are handled.  There are plenty of resources out there to help you determine whether something can be expensed in the year you spend it or if you have to depreciate it and for how long, but using a PM doesn't effect this at all.  I have a mix of properties (some with PM's and some without) and it doesn't effect how I do my expenses.

Tara Piantanida-Kelly · Answer

First, check with your CPA...  It has to do with a couple of things: your income (over $100k?) and whether you can be considered a "real estate professional".  Now I'll share my experience - see if it helps...

When I was single and my income was less than $100K, I got to deduct 100% of my real estate losses (including depreciation) for all of my rental properties, regardless of whether they were self-managed or not.  I had a full-time job (not in real estate), but since my income was below $100K, the "real estate professional" thing didn't come into play.

When I got married in 2012 and our combined income was over $100K, our losses were limited or postponed (because neither one of us could be considered a "real estate professional").

It's my understanding that, in order to be considered a "real estate professional", you (or your spouse, if you're married), must either spend 750 hours in your real estate profession during the calendar year (if you don't have another "real" job), OR spend more time in your real estate profession than you do in your "real" job.

Like I said, check with your tax professional.  I just know it was a real surprise to me when we got our 2012 tax return back.  It made a BIG difference.

Fortunately, I'll be able to file our 2014 taxes as a real estate professional, so we can recoup some of those postponed losses this year (I think).

Good luck and Happy Investing!

Tara Piantanida-Kelly

Curt Davis · Answer

@Adem Tahiri

Any repairs you have to make via the mgmt company you can/should still be able to use when you do your yearly taxes?   I dont see why not.

Dave Toelkes · Answer

@Adem Tahiri

I suspect that you are confused passive income and active participation when you are operating a residential rental income activity.

Please understand that residential rental income is always passive income, always has been in my lifetime as a landlord.  The general rules for passive income activities only allow you to deduct expenses against the passive income for that passive income activity.  Losses in excess of income for that passive activity have to be suspended and carried forward until they can be used against passive income or the activity is sold.

The IRS has given residential rental property owners a special exception to the general rule.  The exception is called the net passive loss allowance.   This exception let you use up to $25K of your NET rental tax loss to offset other ordinary income.  There is a phase out rule that reduces the net passive loss allowance for high income earners.

However, in order to take advantage of the net passive loss allowance, you must be at least a 5% owner of the rental property AND you must ACTIVELY participate in the rental operation.  Active participation in a rental activity does not make the rental income active income -- it is still passive income.  Active participation simply refers to the amount of management oversight you exercise and serves as a qualifier for taking the net passive loss allowance.

I use property managers for all my rental properties, but I do reserve the right to approve certain repair and/or replacement costs, set rents, and approve tenants.  I can also hire and fire property managers.  This "minimum" level of involvement simply gives me the final say on the most important rental management decisions and let me affirm to the IRS that I actively participate in the rental activity even though the professional property manager handles all the day-to-day activities.

BTW, the property management fee you will pay the property manager is also a rental operation expense that you can claim on your Schedule E.  Others have already told you that expenses you pay for or that are deducted from your rental income are always deductible on Schedule E even if you have a property manager.

Hope this addresses your concerns.

Steven Hamilton II · Answer

By the way, Hi Neighbor. Seems we are just a town over.

Steven Hamilton II · Answer

@Jon Holdman covered it rather well.  You must be directing the PM rather than letting them handle everything. You must be able to select from the tenant pool etc.Next,  You always can write of your expenses, the only difference is losses in excess of income are carried over until there is a profit or the property is sold.

@Tara Piantanida-Kelly Prior year passive losses do not get released if you become an RE professional. It only applies to those going forward.

Paul Ewing · Answer

Almost all major expenses like those have to be depreciated over 27.5 years so they will not make much difference in your profit/loss for the property.

You can be active anyway if you are doing the legwork on finding and acquiring properties and working with the management company.  I don't worry about the passive investment anyway because I plan for my properties to all not only being profitable, but producing good cash flow.

If you hire a property management company for a rental, does the rental income become a "passive" investment?

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