There's nothing passive about rental income - allowable tax deductions for active and passive rental income - Brief Article

Nation's Business, Nov, 1996 by Joel Goldhirsch

A simple way to reduce your taxes is to reduce your salary. While this may sound highly unappealing, you may be able to do it without taking a hit in your wallet. All you need is "passive" rental income and deductions to match.

Before exploring this tax-saving strategy, however, it's worthwhile to consider the differences between active and passive income. Active income consists of earned income (W-2 and self-employment) as well as portfolio income (interest and dividends). Passive income is derived from rental equipment or real estate in which you are not engaged on a regular, continuous, and substantial basis.

The typical way to reduce taxes owed on active income is to claim allowable deductions. But deductions from passive rental activities (interest, depreciation taxes, insurance, and maintenance) must be kept separate. If these deductions exceed your rental income, you have a passive-activity loss.

A loss on passive activities cannot be used to cut your taxable income on salary and investments, but there is a way to put those deductions to work to cut your tax bill. Here's an example.

Assume you earn $250,000 in salary and lease personally owned business property at fairly low rental rates. This lease generates a net loss of $50,000.

Tax regulations prevent you from using that loss to reduce your earned income and cut your tax bill. You pay income taxes on the full $250,000.

Now let's reduce your salary by $50,000 and increase the business rental income by the same amount, assuming that the higher rental fee is within fair-market range. You will pay income taxes on $200,000 of salary.

Meanwhile, you will have $50,000 in new passive income. But you won't owe any taxes on this amount because it is offset by your passive loss. The deductions offset the passive income dollar for dollar.

Hence, you still have $260,000 in total income, but your federal income tax is now calculated on $200,000, saving nearly $20,000 for a married couple filing jointly

This strategy works best when you rent equipment or real estate to a business in which you have no ownership involvement. It is possible, however, to rent to your own company as long as you do not "materially participate" in its operation.

Generally, IRS regulations consider rental income derived from a business in which you are a "material" participant as ordinary "active" income, not passive income. Consequently, the rental income is treated as ordinary rather than passive, ruling out the passive-income tax strategy outlined above.

When it comes to rental income, however, there is nothing passive about the tax and financial benefits that can be derived from skillful handling of allowable deductions.

The author is a registered securities and financial-planning representative of CIGNA Financial Advisors, Inc., and Goldhirsh & Goldhirsh, with offices in Irvine, Calif.