TL;DR
- A property’s potential for passive income depends on a few different factors, including what kind of property you purchase and whether you rely on a property manager.
- The IRS calls this process passive activity income, governed by Section 469 of the Internal Revenue Code.
- Rental properties have inherent benefits as well as risks, so landlords shouldn’t expect a downside-free revenue stream.
- Use real metrics to calculate your profits, such as cash-on-cash return and cap rate.
If you’re a first-time investor, you might think of passive income as free money that keeps rolling in while you sleep or take lavish vacations. But after a few 9 p.m. maintenance emergencies, late-paying tenants, or unpermitted pets, that dream of easy money might start to feel more like a nightmare.
Don’t get us wrong: using rental properties for passive income is still a possibility, but they still require at least some investment of your time and money. With that in mind, landlords who go in expecting an easy ride will often be stymied by long hours and meager margins.
The best way to make passive income from rental properties is to know what you’re getting into from the jump (before the first tenant moves in). In this guide, we’re going over how the IRS classifies rental income, how you can dial down your workload, and the numbers that make a rental property investment worthwhile.
What counts as passive income?
Passive income is money that arrives in your bank account with minimal effort on your part, unlike a paycheck, which you have to actively work for. Rent payments, interest, and distributions from a Real Estate Investment Trust (REIT) all qualify as passive income. So do non-rental-related items such as royalties and stock dividends.
Compared with other forms of passive income, rental properties are a relatively steady option. Rent comes in (or should come in) regularly every month, and after you cover your operating costs, you get to keep what’s left for yourself or reinvest it back into your business.
Is rental income passive income?
Even if you have to put in a little active effort here and there, most rental earnings count as passive activity income in the eyes of the IRS. Having that label determines how you should handle losses, gains, and deductions while filing your taxes.
The first and most important rule to keep in mind is that passive losses offset only passive income, not W-2 wages or active business profits. There are two exceptions, however:
- Active participation allows an owner with modified adjusted gross income under $100,000 to deduct up to $25,000 in rental losses against ordinary income (the allowance phases out at $150,000).
- Real estate professional status goes further. Owners who log over 750 hours yearly and spend more than half their working time in real estate may treat a rental they materially participate in as nonpassive (which lifts the $25,000 ceiling).
A landlord wears many hats no matter which exception applies, from screening applicants to coordinating repairs and keeping an airtight paper trail. The tax code calls the income passive even when the calendar disagrees.
What a Rental Really Pays an Owner
Workload aside, the benefits of passive rental income stack up on several fronts. Unfortunately, the risks can add up, too, so you’ll have to weigh the two sides against one another.
Rental property cash flow will arrive on a steady monthly schedule, unless a delinquent tenant or a vacancy disrupts your income. Rent can also work as an inflation hedge, climbing with the market while your fixed mortgage payment stays in one place.
Speaking of your mortgage, tenants can fund your loan payments by helping you chip away at your principal and build valuable equity. Though appreciation isn’t always guaranteed, more often than not, you’ll end up with much more value in the property than you started with. And common breaks like depreciation, mortgage interest, and operating expenses will help minimize your tax burden.
Of course, it’s not all good news. Stretching your finances thin just to buy a rental can lead to major losses, and your investment is locked in one place instead of staying liquid. One big expense, like a roof repair or fixing a hoarding situation, could also wipe out your passive income gains.
Over enough years, though, rental property ownership still tends to reward landlords, provided they’re doing things the right way.
Running the Numbers on a Rental Unit
Good investment outcomes start with cold, hard math. Rental properties for passive income require tenants to cover your operating costs, including loan payments, property taxes, insurance, maintenance, management, and reserves. Only after those conditions are met can you actually start making a profit.
Picture a unit that rents for $1,500 per month and is self-managed (meaning the landlord fields every call themselves). A $1,000 mortgage payment, plus an additional $325 in insurance, taxes, and maintenance costs, would leave that landlord with a little less than $200 in monthly profit. And that’s without hiring a property manager.
With that in mind, rents typically rise over time while a fixed mortgage payment should hold steady, improving that profit margin with every increase. But before investing in rental properties, you’ll need to run the numbers for yourself to determine whether you can count on a rental unit to turn a profit.
How much work should you handle?
The amount of hands-on work associated with a rental property will look different for every landlord, depending on how much free time they have and how much they hope to earn. Generally speaking, rental property investors can choose from these four options:
- Self-management saves the owner the most money, but also requires the most active participation in rental property operations.
- With hybrid management, the owner can handle the big calls like tenant screenings and rent collection, while hiring others to take care of smaller-picture tasks like maintenance and apartment tours.
- The owner can also hire a full-service manager or management company to run all daily operations in exchange for roughly 8% to 12% of monthly rent.
- A turnkey rental property already has a dedicated property manager and tenants in place, making for fully passive income from the moment of purchase. Of course, though, the tradeoff is thinner profit margins.
To top it off, tenant-placement charges, lease-renewal fees, and maintenance markups will also impact a landlord’s expenses. So, you’ll need to compare a full property management fee schedule and do your best to estimate future costs rather than simply relying on basic, current rates for your data.
How to Earn Your Passive Income via Rental Properties
Getting that first rent check and setting up your rental to earn passive income all boils down to a set of easily repeatable steps:
Step 1: Secure your funding and build your investment foundation. Conventional investment-property lenders often ask for 20% to 25% down, plus closing costs and reserves that will see you through a few vacant months or a major property repair.
Step 2: Before you start looking at listings, find the exact market where you want to invest. Check different areas for job and population growth, rent comparables, and how landlord-friendly the state’s rules are.
Step 3: Decide whether to self-manage, go hybrid, hire a manager, or buy turnkey.
Step 4: If you’re looking for a fully passive setup, get your ducks in a row with an agent, lender, attorney, accountant, contractor, and a manager.
Step 5: Do the math on three fronts: cap rate, cash-on-cash return, and break-even occupancy. Cap rate measures your returns before financing, cash-on-cash return is how much the invested cash will earn in a year, and break-even occupancy is how often the unit must stay occupied to cover all of its own bills.
Step 6: Inspect the unit, price it against comparable nearby rental properties, and read the fine print on every lease, payment record, and service contract. An occupied turnkey property requires just as much oversight, since you’ll be dealing with the previous owner’s decisions.
Step 7: Create a solid, repeatable system to handle rent, accounting, and maintenance, so day-to-day tasks like online rent collection and bookkeeping require less hands-on effort.
Invest With Less
If you don’t have the capital to invest in a rental property, you can still earn passive income via house hacking, or renting out a single room or part of your house while living in it.
Or, you can try out rental arbitrage and rent a unit under a long-term lease agreement specifically to re-rent it as a short-term rental (as long as you can find a landlord and a lease agreement that permits it).
Passive Rental Income and Taxes
Whichever route a property owner takes, earning passive income will affect tax filing and payments. Landlords will need to familiarize themselves with IRS Schedule E forms and Publication 527, which separate passive income from wages or active business income.
Landlords can deduct interest, operating costs, and property taxes, and as an added bonus, property taxes don’t count toward a personal State and Local Tax (SALT) deduction. Depreciation of the rental structure and appliances also counts as a deduction, which you can spread across multiple years.
Depreciation isn’t free money, however. The IRS eventually recaptures it as taxable gain when the property sells, and unused losses stay suspended until a sale or until passive income frees them.
Worth noting is that short-term rentals have more complicated tax filing requirements. Depending on average stay length, owner involvement, and similarity to a hotel, these properties may fall outside of standard rental-activity rules and end up on Schedule C as self-employment tax.
You can read more about these requirements at IRS Publication 925.
Investing in Real Estate Without Becoming a Landlord
Of course, direct ownership isn’t the only route to passive real estate investing. Investors who want to get in on today’s red-hot rental market without screening tenants or fielding repair requests have several options, though you’ll have to give up some control of the property:
- Participating in a REIT will provide you with liquid assets, though dividends count as ordinary income and prices swing widely with market conditions.
- Investors sometimes pool their money for larger properties through a syndication, which often requires a minimum investment of $25,000 to $50,000. However, these are usually open only to accredited investors and typically stay illiquid for years.
- You can also invest in rental property via crowdfunding platforms with as little as $10, but fees and potential returns will vary by platform.
- If someone you know wants to become a landlord, you can also offer private lending to help them get started. Of course, you run the risk of your borrower defaulting if the investment turns out poorly.
Sure, these options may be more passive than being a landlord, but if anything goes wrong, you won’t have much say in the matter. It’s absolutely essential to do your research first before you get stuck with a nonprofitable investment that you have no control over.
How to Make “Passive” Income Easier
Rental properties for passive income reward the work you put in up front, and become even more hands-off after you get your systems up and running. Earning that money requires you to run the numbers before you strike a deal, but by taking a realistic approach, you can significantly reduce your workload.
Landlords can also improve their workflow by handing the heavy lifting to property management software. TenantCloud, an industry-leading platform, puts rent collection, accounting, tenant screening, and more in one place, so you can make sure your income actually stays passive.
Sign up for a 14-day free trial to take TenantCloud’s automation and management services for a spin.
Common Questions About Rental Income and Taxes
Is rental income considered passive income by the IRS?
Yes. Under Section 469, most rental income qualifies as passive activity income, even for owners who remain extremely involved in day-to-day management.
How much passive income can rental properties generate?
The answer depends on the market, financing, and management fees. To determine how much you can earn from a rental property, look at cash-on-cash returns, cap rate, and break-even occupancy before you decide to purchase an investment property.
What's the easiest way to earn passive income from real estate?
If you want to earn passive income but aren’t ready to become a hands-on landlord, you can research options like REITs, turnkey rentals, and full-service management. However, each strategy comes with pros and cons, and there’s no fully hands-off method that allows you to keep 100% of the profits.
Do landlords pay self-employment tax on rental income?
Usually not. Rental income sidesteps the 15.3% charge on active business income. Short-term rentals with substantial, hotel-like services are the exception, and the IRS can tax those as a business.
How can an owner make rental income more passive?
Landlords can hire a property manager to oversee daily operations, buy a turnkey rental unit that comes with a tenant and a manager already in place, or streamline tasks like rental accounting, collections, and tenant screening with a reliable system. These strategies all help landlords buy back their time and effort.
