Passive Income

• There are only two types of passive income, according to the IRS: rents and a business in which the taxpayer does not materially participate. Examples in the latter category include royalties from publishing and income from a limited partnership arising out of an investment and not participation in the business itself. Unless you are a real estate professional, typically when you own a rental property, the rent you receive is considered passive income. The benefit of this classification is that if you show a loss in the rental business -- your expenses and depreciation amount to more than the rents -- up to $25,000 of the loss, called passive loss, can be subtracted from your ordinary income and result in lower taxes.
  
  

Capital Loss or Gain

• When you sell a rental property, the profit is called capital gain and a loss is called capital loss. When it comes to losses, a passive loss is better than a capital loss. This is because you can subtract up to $25,000 of passive loss from your income but you can only subtract up to $3,000 of capital loss from income. When it comes to gains, though, capital gains shine. Passive income is taxed at the same rate as ordinary income. By and large, the more you make, the more you are taxed. Capital gains on properties held a year or more are only taxed at a maximum rate of 15 percent, well less than the 35 percent tax affecting the wealthiest individuals.
  
  

Delay the Tax

• While you own rental property, depreciation shields some passive income, but if the final result is income and not loss, you will have to pay taxes on it. When you sell rental property, however, you are allowed to reinvest your profits in another purchase through a process called a deferred exchange or 1031 exchange, which delays taxation. If you use a 1031 exchange on every future sale, you will never have to pay taxes on the capital gains you make on any sale.
  
  

Refinance Instead

• Another legal tactic to delay or avoid taxes on the gain associated with rental property is to refinance instead of sell. If you refinance and take cash out of the property, you do not owe any taxes until you sell the property. Better still, if you sell using a 1031 exchange, refinance the new building to take some cash out and then never sell, you avoid taxation altogether.