Real Life Planning Podcast Ep51: Understanding Schedule E - Part 1
Financial PlanningIn this episode, Vekevia Tillman-Jones dives into one of the most important tax forms for real estate investors—Schedule E. If you own rental properties, understanding how rental income is classified and reported can help you maximize tax efficiency and avoid costly mistakes when working with your tax preparer. She breaks down when to use Schedule E vs. Schedule C, how different business structures affect tax reporting, and why most rental income is considered passive for IRS purposes.
For educational purposes only - we encourage real estate investors to use professional tax advice!
"Most rental real estate income is considered passive income, meaning it’s reported on Schedule E and not subject to self-employment tax. That’s a big deal for tax planning." – Vekevia Tillman-Jones
This week on the Real Life Planning Podcast:
| 💡 | What is Schedule E, and how does it differ from Schedule C? [00:03:07] |
| 💡 | Why most rental income is considered passive (and why that matters for taxes)? [00:05:22] |
| 💡 | How does a Qualified Joint Venture (QJV) help spouses simplify tax filing? [00:16:10] |
| 💡 | Why understanding Schedule E can help real estate investors plan ahead for tax season [00:20:34] |
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About the Real Life Planning Podcast
Hosts Cynthia Meyer and Vekevia Tillman-Jones explore practical steps for real estate investors to build financial freedom and make working for someone else optional.
Transcript for Episode 49
[00:00:11] Vekevia Tillman-Jones: A lot of people like the idea of having rental real estate properties and getting rental income. And I think, that's the straight part- forward part, that you are going to have, associated expenses, but you're going to collect this income, hopefully make a profit and many people, like the idea of potentially having some write offs, right? Or getting all this income from the property, but the expenses and deductions they get to take they keep- get to keep more for themselves and maybe minimize on taxes.
[00:00:38] I think some of the parts can become confusing is when someone is trying to figure out how do they report the income from their rental real estate. Usually, you look at rental real estate properties that you have and you know that you feel like you've done quite a bit of work to get someone in that property or to do any background checks, maybe, calling around to find someone to keep the lawn up or to paint before the new renters gets in. You could feel like you're being very active with that property but when it comes to reporting for the IRS, it doesn't necessarily mean that your income and your activities from your rental real estate properties is going to be seen by the IRS as active income.
[00:01:25] So, um, what does that actually mean?
[00:01:28] If you have rental real estate property, most people might be a bit surprised to find that most rental real estate income is actually considered passive income. So even though you may feel like you've done quite a bit of work, for most people, it will be categorized as passive income. Unlike income, like, maybe you have your own business where you report on a schedule C, for instance. For sole proprietorships and any income that maybe you get a 1099 for. If you provided some services and you received a 1099, that, again, is different than how the rental income will be treated. So the major difference is that income from that 1099 where you have your own business or income- maybe your barber, you have a barbershop or cosmetologist, maybe have your own hair salon or maybe you're a consultant and you're used to reporting that income on Schedule C. Well, Schedule C is for active income and rental real estate income wouldn't be considered active in most situations for real estate investors. And so, instead of reporting on Schedule C, you actually report the income on Schedule E. Schedule E is technically for supplemental income. So it can come from the rental real estate activities, but it can also come like if you maybe either you to whatever degree you are part owner of another type of business structure. Like maybe you have a percentage ownership of a partnership or even maybe your shareholder of an S corporation, so that would also go on Schedule E.
[00:03:07] There are four parts to Schedule E in terms of the types of income that you can report. Most often I found with real estate investors, typically their scenarios pretty much fall under part one and part two and I do say part one and part two because most tend to have either- maybe they have a nine to five still or they like I said before, they may be a partner of a partnership or a shareholder in an S corporation. Maybe they created it themselves, or maybe not. Maybe the business that they're a part of has nothing to do with rental real estate. So they could have income from multiple sources and it's important that real estate investors know which forms, what schedules or, how was their income reported.
[00:03:46] So essentially, if you have a business or you own a business just in your name and it's rental real estate property, and it's just in your name, or maybe you've formed a LLC, but you're the only member of the LLC, so it's considered a single member LLC in terms of where rental income from that property goes, typically for rental real estate income is considered passive, and that's going to be on Part 1 of Schedule E. Part one is for that type of rental real estate income, and it's also for royalties, but we're sticking to the rental income portion for the sake of this video. So you will put any income from a single member LLC or any real estate property, maybe you own the business just in your name, you'll put it on part one.
[00:04:37] Now, if you and your spouse are in it together for your rental real estate, technically you would be considered a partnership, but if you're both participating in it, or maybe both owners, or at least participate in the rental real estate activity, the IRS will allow you to, like, override basically you having to fill out a partnership tax return, and you'll just be able to check off on Part 1 QJV, which is Qualified Joint Venture, which essentially allows you to be treated um, a sole proprietorship. So it allows you to still fall under Section 1 or Part 1, rather of that Schedule E. And you don't have to worry about the extra you know, add forms for a a partnership.
[00:05:22] (How is rental income generally categorized for tax purposes?) As a rental real estate investor, it's important to understand how your income will be categorized and how important figures like your rental income or rental loss and any expenses will get reported for tax and tracking purposes. Now, most rental real estate income is considered passive income and so, any associated rental loss that you would have would also fall under that same category and would be considered a passive loss. Now that comes into play for rental real estate investors and business owners who own real estate property like maybe they have one or more single family homes or maybe even a multi unit property. They could also have a commercial property and that they might lease or rent out or maybe they even have an apartment complex. So the income from those properties is considered passive and not earned income. It's also what the IRS would consider supplemental income. And now the form, or the IRS form that you would use to report supplemental income and loss is Schedule E.
[00:06:28] Now, I'm not a CPA, and this is not meant to be tax advice in any way, but it's more of a guide to help rental real estate Investors understand how schedule is used and what it exactly means for tax reporting. Now, many of these business owners have multiple sources of income in addition to the income that they get from their rental real estate, they might actually still have a 9 to 5 or maybe they're doing a part time job, right? And they may have some business that they own, their own business, and maybe they're a consultant or maybe they are a barber. They have their own barber shop. It could be just any business that they directly own or are part owners of.
[00:07:10] Now, that's important because only some of their income in that situation would actually go on schedule E, which is for supplemental income. It's important to note here that supplemental income, it does not include any income that you receive as W-2 wages from your employer, nor does it include any income that you would likely be subject to paying self employment tax on. So again, like your own business or anywhere, any type of business where you're sole proprietorship. So this includes, like, any income that you receive a 1099 for and again, any income that you might make as a barber, you have your own barbershop or income, even, it would also include income that if you're in the business of flipping real estate, that's also not considered supplemental income. That would be active income, most likely.
[00:08:01] So then what is considered supplemental income? (When is income considered supplemental income?) Rental real estate and loss is actually not going to be the only type of supplemental income and loss that you report on Schedule E. In fact, there are actually four different categories of income and loss that are reported on Schedule E.
[00:08:17] Part one is for income from rental real estate, but it's also from royalties. Most often with real estate investors, we're not necessarily dealing with the royalty part, but an example of royalty income would be maybe, you have land and someone's using your land to make income and you get a portion of it or maybe you have any other intellectual property like a book or copyright or music that you receive income from, not active income, you're not actively still doing that, but maybe you made a book years ago, you don't write books anymore, you still get income from sales of the book you wrote. And so those are other types of income that could be considered supplemental. That's on part one.
[00:08:55] Now part two is for income that you receive as a part of a partnership or S corporation. So, you get income from those sources and then part three is for income or loss from estates and trust and part four is front to report income or loss from real estate mortgage investment conduits.
[00:09:16] Now I don't usually see too much on the fourth one with most real estate investors. So like I said, for this video, we'll focus on part one and part two, which is the rental real estate income, as well as the income from partnerships and S corporations. For most real estate investors, those are the two that they'll typically have income fall into.
[00:09:39] How do you know if you should use Schedule E versus Schedule C? Now that's important to know because there's several distinctions. The big thing is that, how that income would be taxed. So Schedule C income literally comes from self employment activities where you are actively running a business. You know you're involved in the operations of that business. Think like a maybe a cosmetologist who owns a salon or maybe someone involved in landscape and they're mowing the lawns each day. Schedule C income is going to be subject to self employment tax. Now, I mentioned this a bit before, some rental income actually could be considered active.
[00:10:21] An example of this actually might be a short term rental, like maybe that you have on Airbnb because you're not completely hands off with that type of rental. You typically offer what the IRS would define as substantial services, and those services are primarily for like your tenants convenience. These services are well above basic services that would be needed to maintain a rental property. So you might provide maid services or have the linens changed every day during each guest stay, or you might even provide meals and entertainment. Because those are substantial services that you're providing, the IRS says that you're a lot more active so that all of, or a portion of the income from that short term rental might actually need to be reported on Schedule C.
[00:11:06] Now if you think about that income on the other side with a typical rental property, you aren't providing substantial services like those. Instead, you are offering basic things like heating and air conditioning, water and gas and standard repairs and maintenance. (Is there self employment tax on rental income?)
[00:11:22] Determining whether the income or loss from supplemental income is reported on part one or part two of Schedule E is going to depend on a number of things like who owns the business? Who the members of the business are? And then also the business entity or structure of that business is going to come into play. However remember, the IRS treats rental real estate income as passive income for tax purposes, so in that same scenario where you own that rental real estate only in your name or as a single member LLC, that would not be reported on schedule C.
[00:11:59] Vekevia Tillman-Jones: Instead, it's going to be reported on Schedule E- part one, in fact, Schedule E. And schedule E income is not subject to self employment tax. So that's a very important distinction.
[00:12:11] You might even say, what if you and your spouse own the business together or at least participate in the business together?
[00:12:16] Now, typically, if there's going to be more than one owner, the business is going to be considered a partnership, unless you elect a different structure, like a LLC or LLC taxes as a S corporation, a C corporation, for instance. But partnerships file an informational partnership tax return, but spouses can actually avoid having to file that extra partnership form if they meet what the IRS says is a qualified joint venture.
[00:12:43] However, if it's rental real estate income, it's considered passive. So now we're thinking about Schedule E. And the same will go for rental real estate income that you and your spouse own or work together in, though it's technically a partnership if you meet the IRS qualifications for the business to be considered a qualified joint venture, you can still avoid the actual partnership forms by electing QJV which again stands for Qualified Joint Venture on Part 1 of Schedule E.
[00:13:17] So how does it work if you set up a business as a multi member LLC in which case you and your spouse are the only members? So technically a qualified joint venture election is not an option for a multi member LLC. However, let's say you have a multi member LLC where you and your spouse are the only members.
[00:13:39] The option to elect it is technically not allowed unless you live in one of nine community property states like California, Texas, for instance.
[00:13:52] I would say that would be an area to consult with a tax professional to confirm what tax forms the LLC would need to file and how it'll be reported on Schedule E.
[00:14:02] Vekevia Tillman-Jones: So how would it work if you and your spouse have a multi member LLC in a non community property state? Most states are non community property states. And if you and your spouse own a multi member LLC in a non community property state, you're only two members, you don't have the option to treat the business as a sole proprietorship.
[00:14:23] Instead, you're going to need to be a multi member LLC, which is by default considered a partnership. Now, I would suggest consulting with a tax professional still just to see which tax forms are required for you.
[00:14:39] What about when there is a multi member LLC in which you are one of multiple members and your spouse is either not the only other member or maybe they're not a member at all? By default, the multi member LLC is treated as a partnership regardless of whether the only other partner is your spouse. But owners of a multi member LLC can elect to have the LLC to be taxed as either a partnership or an S corporation. Partnerships and S corporations have their own informational business tax return and associated tax forms to file. As for the income or loss reportable to you and your spouse, if applicable, as the partner of that partnership or as a shareholder of the S corporation, the business reports your share of income and loss and deductions, et cetera, on schedule K-1. So each partner is going to get a schedule K-1 and use that schedule K-1 to report their own share of income and losses on Part 2 of Schedule E. So now, in this situation of Part 2 of Schedule E, that income coming from the S Corporation or the partnership doesn't necessarily have to be from rental real estate activities. It could be, but it could also just be from any other activity that you receive from participating as a partner or shareholder in those types of entities. So that's different from part one of Schedule E where you only report income from rental real estate income and from royalties as well, but specific rental real estate income. Your K-1 is going to list your income and loss from the partnership or S Corporation as either passive or non passive, and you'll indicate that on part two of Schedule E. A tax advisor can help you determine which category your income would fall into.
[00:16:27] Now, why does all of this matter? Income from Schedule E is not subject to self employment tax, whereas income listed on Schedule C is. Most rental real estate income is going to be considered passive income that will be listed on Schedule E, which is the IRS form to report supplemental income and loss. As a real estate investor, you might own rental properties in your own name or joint with your spouse, or you may have a business and choose a business structure such as a partnership or LLC or maybe even a LLC taxed as an S-Corp. In most cases, you still use Schedule E to report any associated rental real estate income and loss. You may even be part owners of a partnership or an S corporation is not involved in rental real estate and you still report on Schedule E. So Schedule E is definitely one of the IRS tax forms to familiarize yourself with as a real estate investor.
[00:17:24] It's important to understand how your income and losses are categorized and how who owns the business or is a part owner of the business, as well as how the business is structured influences how and where things are recorded on schedule. Having a good understanding of schedule, you will help make things so much clearer if you're handling your taxes on your own or working with a bookkeeper to keep reporting throughout the year. Keep that organized. It'll especially come in handy when you're working with your CPA or your tax professional to plan ahead for your taxIf you like this video podcast, consider joining Real Life Planning’s Question of the Week where our CERTIFIED FINANCIAL PLANNERs™ and rental property business owners answer the most common questions about real estate financial planning direct to your inbox.
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