Q&A: Long-term holds vs rent-to-owns: inactive vs. active income?

Posted on: February 27th, 2014 by Real Estate Accountants 2 Comments

Lego HousesQ.  We currently own 6 revenue properties, and over the last 6 years we have sold 5 revenue properties. We have always been buy and hold. We are considering entering into a Rent-to-Own agreement and I understand it will be taxed as active business income. It would be a one year or two year term. My question is does this put my holds at risk of the same tax treatment or is it easy to keep the two strategies separated for income tax purposes?

A. Generally, speaking I believe it’s fairly easy to differentiate. The primary reason for this is that you will presumably have a contract outlining the option agreement with the Rent-to-Own which clearly will not exist with the long-term holds. They can be further segregated through the use of corporations, but I believe this to be more relevant where there is flipping of properties.

As a side note, it’s my opinion that the rental income portion of your RTOs would still be treated as inactive income. It’s further my opinion that the excess rent that is typically charged in RTO agreements would be active income, similar to the initial option deposit and the ultimate gain on disposition. Exceptions, of course, apply.

George E. Dube CPA, CA

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2 Responses

  1. Tris Winfield says:

    \”it’s my opinion that the rental income portion of your RTOs would still be treated as inactive income.\”

    – what do you mean by inactive income – is that primarily to differentiate it from active income or is this a tax term all on its own? I\’ve never heard of inactive income, only passive and active. thks

    • Real Estate Accountants says:

      From a tax perspective, passive income is used interchangeably with inactive income.

      That said, in a non-tax environment, a number of investors and organizations will refer to passive investing as investing in second mortgages, stock market-based investments, and limited partnerships (for example, real estate development) as primary examples. They consider investments in traditional real estate as more active/time-consuming given the need to manage the real estate portfolio more, in a similar way to other business activities.

      – George Dube