The following excerpt is from the current edition of Tax Benefits of Ownership, which gives an explanation and overview of the three income categories and the different classifications of real estate they encompass.

The many types of income 

To analyze an owner’s annual reporting of real estate operations, financing, and sales, it is essential to understand the three income categories for income tax reporting, sometimes referred to as income pots. Each category sets the accounting and reporting procedures for the income, profit and loss incurred by properties classified as within the category.  Collectively, income, profit and loss are called income.

When an agent’s estimate of the owner’s annual income tax liability is prepared, the owner’s income from all sources needs to first be classified as belonging in one of three income categories:

  • The trade or business income category – income from professional trade or owner-operated business opportunities, which includes real estate owned and used to operate the trade or business [Internal Revenue Code §469(c)(6)];
  • The passive income category – income and profits from managed rental property investments and business opportunities owned or co-owned but operated by others [IRC §469(c)(1)]; and
  • The portfolio income category – income and profits from management-free investments. [Revenue Regulations §1.469-2T(c)(3)]

Each income category encompasses a separate classification of real estate based on its type and use for generating income, profit, or loss. The particular vesting employed by the owner or co-owners to hold title does not determine income category. Thus, vesting is not relevant for category classification, unless a C corporation, taxable trust or the estate of a deceased person is the owner-operator. These are taxed separately from their owners who are shareholders and beneficiaries.

For example, the ownership of a rental (e.g., the average tenant occupancy exceeds 30 days) by a limited liability company (LLC) is not a trade or business of the LLC or its owners, called members. Each member of the LLC reports their pro-rata share of the income from a rental operation as passive category income, since an LLC is a pass-through entity, also called a disregarded entity.

An LLC is treated as a partnership unless it elects to be taxed as a C Corporation, which eliminates any pass-through entity treatment. Thus, as in any partnership, income of an LLC is “passed through” to the members, who are in turn liable for any income tax. [IRC §701]

Conversely, property management services rendered by an individual who is a broker on behalf of rental owners constitute a trade or business category activity for the broker.  Not so for the owner, as the property is a passive investment no matter who manages it.

Mutually exclusive income for no commingling with losses 

The three income categories are mutually exclusive of one another. Simply put, losses from one category cannot be used — commingled — to directly offset income or profit in another category. Each category is annually tallied separately to establish the end-of-year income or loss within that category.

The reportable end-of-year income or profit within all income categories are, before considering any reportable losses, initially added together to start the process of establishing the owner’s adjusted gross income (AGI). The handling of reportable annual loses as an adjustment to AGI is different for each income category.

For a business income category, all reportable losses are fully subtracted to reduce the AGI in the year incurred. No limitation or carryforward treatment exists for trade or business losses.

In contrast, reportable losses in the passive income category do not automatically reduce the AGI the year they are incurred.  Unless the owner otherwise qualifies, passive losses are carried forward within the category, allocated only to the properties generating the category loss for use in future years, called a suspended loss.

Suspended rental operating losses are deductible in future years when used to offset operating income or sales profit from the property which generated the loss, called tracking.

When a sale of rental property occurs and the suspended loss carried forward is greater than the profits on the sale, the operating loss remaining spills over to reduce the AGI. This lack-of-profit situation may exist when a property becomes obsolete or is subject to extensive reduction in local population of renters.

However, and critically, the owner of passive category rental property may write off the loss in the year it occurs when the owner’s activities qualify rental losses for either:

  • a real estate related business loss adjustment to lower their AGI; or
  • a $25,000 rental loss deduction from AGI to lower their taxable income.

The tracking of operating income or loss for each assessor-identified parcel of passive category property owned by the taxpayer is unique to the passive income category. No commingling of income from one property with the losses of another property is allowed. With tracking, each separately assessed parcel of rental property the investor owns is accounted for independent of all other parcels of rental property the investor owns, except for multiple ownerships within the same complex or project.

Tracking maintains the integrity of requiring suspended losses to only offset future income or profit from the property generating the operating loss. The tracking requirement does not exist in the business or portfolio income categories.

Portfolio losses remain portfolio losses

In contrast, portfolio investments — such as management-free income property with net leases and unimproved land held for profit on resale — are batched to calculate the annual income from all properties in the portfolio category. The portfolio category also includes intangibles such as stocks, bonds, and mortgages.

When assets in the portfolio category collectively produce an annual operating loss, that operating loss is carried forward within the category to offset portfolio category income or profits in future years. An end-of-year portfolio category loss cannot be subtracted to reduce the owner’s AGI, but for a $3,000 amount. However, unlike passive income accounting, no tracking of operating losses for each separate property takes place. Portfolio assets are commingled within the category for simplified accounting.

Again, for offsetting between categories, the end-of-year income, profits and losses are first totaled within each category. The totals from each category are then brought together (subject to limitations on passive or portfolio losses) to establish the owner’s AGI.

For the owner’s agent to analyze and estimate the owner’s annual income tax liability resulting from a sale of real estate, two major tax components need to be estimated:

  • the owner’s AGI, derived from net annual operating income and sales profits generated within each income category, less permissible losses; and
  • the owner’s taxable income, derived by subtracting from their AGI the owner’s itemized or standard personal deductions, exemptions, and any $25,000 rental property operating loss deduction. [IRC §469(i)]

The trade or business income category

Trade or business income includes:

  • earnings from an individual’s trade or business and real estate used to operate their trade or business, including ordinary income from the sale of parcels held in inventory as a subdivider, builder, or dealer [IRC §469(c)(6)(A)];
  • income and losses from the individual’s business opportunity (sole ownership, partnership, LLC or S corporation) and the real estate owned and used in the business, when the individual is a material participant in the management of the business [IRC §469(c)(1)]; and
  • income and losses from the individual’s owner-operated hotel, motel, or inn operations (sole ownership, partnership, LLC or S corporation) with average occupancies of 30 days or less, when the individual is a material participant in management. [Rev. Regs. §1.469-1T(e)(3)(ii)(B)]

The passive category for rentals actively managed

An individual’s income property operations (excluding business category hotels, motels, inns, and portfolio income from management-free net leases), referred to by the IRS as rental income, are accounted for within the passive income category.

The passive income category includes:

  • rents, expenses, mortgage interest, depreciation from annual operations, and profit and losses from sales of residential and commercial rental real estate with an average occupancy of more than 30 days (inclusion of a property’s income requires active management under rental or gross lease agreements); and
  • income or losses from business opportunities owned or co-owned, but not operated or managed by the owner or co-owner, called passive ownership. [IRC §469(c)]

Income received from rental operations is often referred to as passive income. Ironically, for income property to be a rental, and thus reported in the passive income category, the owner needs to be obligated to actively manage the property.

To be considered involved in the active management of a property, the landlord needs to have some legal responsibility to care for the property under their rental or lease agreements, typically called gross leases. When the landlord has no contractual responsibility for care and maintenance of the property the income property becomes a portfolio category property. This occurs in a long-term net lease agreement where the tenant agrees to care for and maintain the property and structures and pay all property operating expenses.

And for active management of a rental property, the owner who further qualifies as a material participant in its management may write off all rental operating losses for the year against income from all categories. The passive losses written off by a material participant reduce their AGI and, in turn, their taxable income. [IRC §469(c)(7)]

The portfolio category

Investment income, profits and losses taken by an individual, referred to as portfolio income by the IRS, includes:

  • interest earned on bonds, savings accounts and secured or unsecured notes (such as carryback trust deeds notes, trust deed loans, and interest on delayed §1031 reinvestment funds);
  • annuities, dividends, and royalties from personal property investments (such as stocks, bonds, and commodities); and
  • income from the ownership of land subject to ground leases, management-free net leased real estate, and unimproved land held for profit on resale. [IRC §469(e)(1)(A)]