Rental Business: Active vs Passive Income

[Bradley Pitts]

Hi,

I think I understand the difference between active and passive income. Passive income applies to most small landlords/owners as they collect rent from tenants. This also applies to investors who collect interest or dividends from stocks. I think investors can use expenses to reduce their taxable income, with the hope of reducing it to zero. However I think it's bottoms out at zero - any losses become NOLs which the investors hopefully can use to reduce future taxable income.

Conversely, active income applies to the landlord who is rolling up his sleeves and getting much more involved in his rental business. Maybe he spends 20 hours a week doing financial modeling, managing the budget, or visiting his properties. I'm not sure what the exact definition would be. I believe that one big difference with active income is that you MUST pay self-employment tax on it, whereas passive income is exempt from this requirement. I believe the same concept of NOLs apply to active income as well - once your income reaches zero, any further loses become NOLs and are used in the future to reduce taxable income. The other big difference I've heard is that you are easily able to deduct other expenses which support your income-generating activity.

My big question is - what else is the main advantage of active income over passive income? Isn't it true that under both scenarios, you are able to deduct expenses which support that income-generating activity (e.g. deducting fees paid to show your listing online, deducting interest expense, deducting HOA dues, etc). If this is all true, I don't really see a benefit to being labeled as Active Income vs Passive Income (from the IRS' perspective).

Thanks