Real estate investing has long been considered a popular avenue for people to earn passive income. Rental properties, in particular, are often touted as a way to earn money without active participation. However, the true passivity of rental income can be a subject of debate. In this blog post, we’ll examine whether rental income is genuinely passive and explore how the stock market may offer a more hands-off income option.
Understanding Rental Income and Passive Activities
Rental income refers to the money earned from renting out a property, whether it is a personal residence, a vacation home, or a traditional rental property. The Internal Revenue Service (IRS) distinguishes between rental activities and other real estate activities, with the former often considered passive rather than active income.
The IRS defines passive activities as those in which an individual does not materially participate. Material participation requires passing one of the seven tests listed by the IRS, such as participation in the activity for more than 500 hours.
Since rental income is typically considered passive, taxpayers are limited in the amount of deductions they’re allowed to take in years where their rental real estate generates a loss.
The Nature of Rental Activity
While rental income may appear passive on the surface, it often involves various responsibilities and management tasks that demand active engagement. For instance, acquiring tenants, handling repairs and maintenance, addressing complaints, and managing financial aspects all require ongoing effort. Additionally, short-term rentals or vacation rentals may necessitate more frequent involvement.
On top of dealing with the realities of being a landlord, the rental property is not liquid. If you have an emergency and need access to funds, you’ll have to look elsewhere to come up with the cash.
Real Estate Professionals
Individuals who meet the IRS requirements to be classified as a real-estate professional:
Spent 750-plus hours during the tax year servicing real property trades or businesses in which they materially participated.
More than half of the personal services performed during the year were in real property trades or businesses in which they materially participated.
This classification allows the taxpayer to treat rental income as non-passive, offsetting it against losses and potentially reducing their tax liability.
The Stock Market: A Truly Passive Investment Option
While real estate can provide a steady stream of income, the stock market offers an alternative path to passive investing. Investing in stocks, bonds, or index funds allows individuals to participate in the growth of companies without the need for active management. Here are some reasons why the stock market can be considered a more passive investment:
Minimal time commitment: Investing in the stock market requires significantly less time and effort than actively managing rental properties. Once the initial research and portfolio allocation are done, monitoring investments can be as simple as periodic check-ins.
Diversification: By investing in a broad range of stocks or index funds, investors can diversify their holdings across various industries, reducing the risk associated with individual companies or sectors. This passive diversification minimizes the need for constant involvement in managing investments.
Professional management: Mutual funds or index funds are often managed by professionals who actively monitor and adjust the portfolio. Investors can benefit from their expertise without the need for constant decision-making.
Liquidity: Unlike real estate, which often requires significant time and effort to buy or sell, stocks can be bought or sold with relative ease. This liquidity provides flexibility for investors to adjust their portfolios as needed.
Conclusion
While rental income is often labeled as passive, the true nature of its passivity depends on the level of involvement and the classification of the rental activity. Despite the potential for passive income, managing rental properties can demand significant time and effort.
Alternatively, the stock market offers a genuinely passive investment option. With lower time commitments, professional management, and easy liquidity, investors can participate in the growth of companies without the same level of active involvement.
Discuss your situation with a fee-only financial advisor.