Active vs. Passive Income: Understanding Real Estate Investment with Derek Fujikawa
Real estate investment is a popular and proven way to build wealth and achieve financial goals. However, it's important to understand the difference between active and passive income when it comes to real estate investing. In this blog post, we'll explore these distinctions, examine real estate tax benefits, and provide tips for maximizing your investments.
Active vs. Passive Income
Active income is money earned by actively working, such as a W-2 job or owning a business. Passive income, on the other hand, is generated without direct daily involvement, such as rental properties or investment income.
The IRS categorizes real estate income as passive, with some exceptions like real estate professional status or short-term rental properties. Understanding these distinctions is important because they have tax implications that can impact your bottom line.
Types of Income
There are three main types of income: active, passive, and investment. Active income includes your W-2 job and self-employment earnings. Passive income consists of rental properties, dividends, and other investments that generate money without your direct involvement. Investment income includes stocks, bonds, and real estate purchased for investment purposes.
When it comes to real estate investment, understanding the difference between passive and active income is key. Passive income is generated from rental properties or other real estate investments that generate income without your direct involvement. Active income, on the other hand, is generated from actively working in the real estate industry.
Real Estate Professional Status
Real estate professional status allows individuals to treat passive income or losses as active income. To qualify, one must spend more than half of their time managing real estate properties. This status is especially beneficial for those with a high W-2 income, as it allows them to offset losses from real estate investments against their active income.
Becoming a real estate professional and managing your own properties can be a great way to take advantage of this tax benefit. However, it's important to note that there are some strict requirements that must be met in order to qualify for this status.
Short-term vs. Long-term Rentals
Short-term rentals, defined as properties rented for an average of seven days or less, are considered active income. If an investor participates in managing these properties for at least 500 hours per year, the income can be deducted against their W-2 income. Long-term rentals, on the other hand, are classified as passive income.
Understanding the difference between short-term and long-term rentals is important because it can impact your tax liability. Short-term rentals can be a great way to generate income and take advantage of tax benefits, but they do require more involvement than long-term rentals.
Maximizing Your Investments
To offset a high W-2 income, one option is for a spouse to become a real estate professional. By filing a joint return, the losses from the real estate professional can offset the other spouse's W-2 income.
Another option is investing in short-term rental properties, which can be deducted against your active income if you meet the 500-hour participation requirement. Maximizing your retirement savings, such as 401(k) or IRA contributions, can also help reduce your taxable income. Additionally, consider the backdoor Roth IRA strategy for tax-free growth if you don't qualify for a regular Roth IRA.
Understanding the difference between active and passive income, as well as the tax implications, is essential for real estate investors. By strategically utilizing real estate professional status, short-term rentals, and maximizing retirement savings, you can optimize your investment portfolio and enjoy the financial benefits of real estate investments.
In conclusion, real estate investing can be a great way to achieve financial goals and build wealth. Understanding the difference between passive and active income, as well as the tax implications of each, is crucial to making informed investment decisions. By taking advantage of tax benefits like real estate professional status and short-term rentals, and maximizing retirement savings, you can optimize your investments and achieve financial success
Derek T. Fujikawa, CPA
Derek Fujikawa and his father Stan opened Fujikawa & Associate, CPA in 1997. As a managing partner, Derek specializes in stock compensation tax issues. He received his degree in Business Economics from UC Santa Barbara with an emphasis in Accounting. He is member of the CA Society of CPAs, AICPA, FPA, and a Board Member for the San Jose Community Youth Service. He is the Assistant Cubmaster for Cub Scout pack 611.
Outside of the office Derek roots for the San Francisco Giants, San Francisco 49ers and the Golden State Warriors. He is also a youth basketball coach. Derek enjoys spending time with his family, traveling and reading.
derek@fujikawacpa.com
(408) 260-7977 x
