Passive income, part 1: Is it taxable?

For many real estate investors — and investors in general — passive income is the holy grail. This is the income that is earned from rental properties, limited partnerships, or other enterprises where the investor is not directly involved in the day-to-day operations.

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In part one of this series, we’ll address the question as to whether or not this type of income is taxable.

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The short answer is yes, but it depends on the specific situation — so today, let’s go over some of these situations and the subsequent ways the income they generate is taxed.

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Rental properties

Rental income is considered passive income because the investor is not actively involved in the management of the property. However, this income is still taxable. The IRS requires investors to report all rental income on their tax returns. In addition, investors can also deduct certain expenses related to the property, such as mortgage interest, property taxes, and repairs. This can help to reduce the overall tax liability on rental income.

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Limited partnerships

Another common way to earn passive income in real estate is through limited partnerships. In this type of arrangement, the investor provides capital to a partnership that purchases and manages real estate. The investor is not involved in the day-to-day operations of the partnership, but earns a share of the profits. This income is also taxable, but it is treated differently than rental income. The investor will receive a Schedule K-1 form from the partnership that reports their share of the income and expenses. This income is then reported on the investor's tax return.

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Real estate investment trusts (REITs)

Real estate investment trusts (REITs) are another way for investors to earn passive income in real estate. REITs are companies that own and manage income-producing real estate. Investors can purchase shares in the REIT and earn a share of the income generated by the properties. This income is also taxable, but it is treated differently than rental income and limited partnership income. The income from REITs is considered dividend income and is taxed at the investor's ordinary income tax rate.

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In conclusion, passive income from real estate is taxable — rental income, limited partnership income, and REIT income are all subject to taxation. However, investors can take advantage of certain deductions and tax strategies to reduce their overall tax liability. It is important for real estate investors to understand the tax implications of their investments and to work with a qualified tax professional to ensure compliance with IRS regulations.

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