When it comes to taxes, is managing rental properties a business or an investment?
You should know how to classify your rental activity at tax time, whether you are a landlord of a single-family rental or you own a share of a large apartment building.
Do you own a business, or are you an investor?
This article aims to help you understand the differences between the two types of deductibles and how business owners can save money on them.
Rentals that qualify as a business
If you can show your rentals are “for-profit” and that you work at this business “regularly and continuously,” your activity qualifies as a business.
Landlords can hire contractors and managers to do much of the work on their property, but they must also be involved in managing the rentals. As long as you are marketing the space for rent, vacant rental units do not preclude you from qualifying as a business owner.
The IRS considers these factors in determining if your rental activity is a business:
- Whether you own a commercial or residential rental property
- How many properties do you rent out
- Whether you or your agent are involved
- The length of the lease, such as a short-term or long-term lease
- The types of ancillary services the landlord provides
- Whether you have filed all necessary paperwork
In addition, you can prove you are operating a business with your rental property in the following ways:
The ‘three of five years’ test
The IRS considers you a business if you have earned a profit in three out of the past five years. This requirement must be met, or a behavior test must be passed.
The behavior test
If you meet the behavior test criteria, you can operate rental properties at a loss every year and still qualify as a business owner. In this situation, an IRS auditor will look at the following:
- Operations. Would a business operate the same way?
- Expertise. Are you knowledgeable about real estate?
- Time and effort. When it comes to renting out your property, how much time do you devote to it?
- Experience. Do you have a track record of success in the business? How long have you been in the business?
- Money management. Are you profitable or losing money?
- Appreciation. During the time you have owned your property, how has its value changed?
- Your net worth. Have you earned other income or amassed assets?
- Your lifestyle. While not working as a landlord, how do you spend your free time?
It is essential that you keep excellent records of your real estate activities in order to pass the behavior test. Expertise can be established with references, blogs, speeches, and podcasts.
Rentals that don’t qualify as a business
When landlords do one or more of the following, they do not qualify as business owners:Purchase land that will be sold in the futurepassively invest in mortgage notesparticipate in real estate syndications as a limited partnerRenting out a few units that don’t require much maintenance and are leased out regularlyOwning triple net lease properties
Advantages of owning a business versus investing
You should always choose a business-oriented rental activity over an investment activity if tax purposes are concerned. There are several items you can deduct when operating a real estate business:
- Costs associated with starting a business
- Home office expenseS
- Passive losses on real estate
- Expenses related to attending conferences and conventions
- IRS Section 179 expenses
Under the new pass-through deduction rules, a landlord who qualifies as a business owner can deduct up to 20% of their net rental income from 2018 through 2025.
Tax Cuts and Jobs Act (TCJA), the tax reform package passed in 2018, included this deduction, also known as the Safe Harbor Rule. However, unless Congress votes to extend the deduction, it will end on January 1, 2026.
It is optional to use the safe harbor rule. However, a landlord must meet the following requirements:
- Provide rental real estate services for a minimum of 250 hours per year (including employee and agent work).
- Document the rental services for these properties.
- Document each enterprise’s income and expenses separately.
The Safe Harbor Rule does not apply to landlords who live in their rental property for more than 14 days per year. Therefore, in most cases, hosts of short-term rentals cannot claim the deduction due to this requirement.
In conclusion, landlords must keep accurate records. Maintaining accurate and organized records is essential for managing your rental property, preparing your financial statements, tracking your expenses, preparing your tax returns, and supporting anything you report on your tax returns.
If you are in the market for buying or selling a home, Reeds Real Estate is your best choice in Chesapeake, Virginia to help you. Call us at (757) 799-4824 or fill out the form below.
