When we first start out as investors we just worry about getting our first deal done. Then we start to worry about getting our next deal done and often forget to consider the tax consequences. If you do different types of deals, you may want to separate your real estate income to net more dollars in your pocket at the end of the day.
The Two Types of Income
There are two types of real estate income – active and passive.
Active income is earned when you undertake activities with a short term exit to make a quick profit. Things like rehabs, flips and lease options could be considered active income.
Passive income is earned when you invest with a longer time horizon. If you utilize the traditional buy and hold strategy, your real estate earnings would most likely be considered passive income.
Why You Should Keep Your Real Estate Incomes Separate
The reason to separate is simple – tax consequences. Passive income is treated more favorably than active income, so you want to keep as much of your income as possible under the passive classification.
If you have a few buy and hold properties in your portfolio and start to take on some more “active” type projects, you risk having all of your real estate activities classified as active. In this case, your profits will be taxed as income rather than capital gains. This difference in tax treatment can make a huge difference in your tax bill when you dispose of a property which has built up substantial equity over the years.
Take the time to separate your real estate activities and operate each strategy under a separate company. The time invested upfront will save you thousands of dollars down the road.
Always consult an accountant when making tax decisions for your business.