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Understanding Landlord Tax Classifications

September 30, 2022

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Why You Need To Understand Landlord Tax Classifications

Taxes. Often, just the word makes people shudder. 

As a landlord, taxes are a key part of your business.  

The more you understand their nuances, the more successful your business will become. 

And before you can take advantage of those critical tax deductions, you need to determine your IRS classification for tax purposes.  

If you’re a landlord and make a profit, you probably qualify for all the deductions available for rental business owners. However, if you obtained your property via special circumstances (e.g., a gift or inheritance) or aren’t actively renting it out to tenants, you may only qualify for some deductions or none at all. 

The Factors 

The two key factors that help the IRS decide how to classify you are motive and behavior. If the IRS can determine that your main motivation is profit, then you meet the criteria for motive. 

Even if you don’t meet the motive criteria, you can still meet the behavior criteria. For instance, if you behave as if you intend to make a profit with your rental activities, the IRS will still consider you a business owner. The behavior the IRS is looking for is dependent on you or someone you hire demonstrating consistent, day-to-day involvement in managing your properties. You must also regularly file all the required information returns and keep good records of your profits and losses. 

Other factors the IRS uses to determine your classification include the type of property you own (residential vs. commercial), the number of units you rent, the nature of any secondary services you offer your tenants, and the lease term length. 

The Classifications 

Now that we’ve gone over the main two determining factors, let’s look at the actual classifications. We’re going to cover the main three in this article: 

1. Investor – This IRS classification goes for anyone who passively invests funds into a business with the hope that its value will increase over time.  

For instance, if you inherit a property from your cousin but don’t list it anywhere or attempt to lease it, you’re an investor, not a business owner. To be considered a business owner, you must assess and prepare the property, list it somewhere, and actively seek a tenant.  

You might also fall under the investor label if your tenants manage the whole property, pay taxes, and buy insurance. In this situation, you aren’t performing the daily tasks of managing the rental unit, so you’re an investor. 

Investors can take advantage of some tax deductions, including repair costs, interest, depreciation, and certain operating expenses. That being said, they cannot claim other business-only deductions.

2. Not-for-profit Owner. This IRS classification applies to you if your activities qualify as not-for-profit. If your primary motive for rental activities is anything other than profit, you fall under this category.  

For example, if you use a property for recreation or charity, you’re a not-for-profit owner. Or let’s say you own a condominium in California that you visit five to six months out of the year and allow your family members to use it for the months you’re not there. This is another instance where you’ll be considered a not-for-profit owner.  

This IRS classification has the harshest tax consequences. You cannot deduct any of your rental expenses under this label. Thus, your full rental income will be taxed even if you spend substantial money on repairs, renovations, or insurance.  

3. Business Owner. For tax purposes, you should try your best to be classified as a business owner. How do you do that? The key is that you (or someone you hired) consistently and continuously engage in rental activities with the intention of making a profit. 

And, as we clarified earlier, you don’t have to do everything yourself. Let’s say you inherit two properties from Aunt Edna. You check out the properties, make a few repairs, and post them on the internet. Next, you hire a property manager to screen new tenants, collect rent, and hire technicians while you return to your other job. At the end of the year, you profited from your property manager’s actions. And because a person you hired works consistently and continuously to manage the rentals, you still qualify as a business owner. 

Tax Deductions for Business Owners 

As we just established, the business owner classification is the best for tax purposes. So, what tax deductions for rental property make it so great?  

  • Pass-through income allows rental business owners to deduct up to 20% of their net rental income from income tax with the pass-through deduction. 
  • Real estate losses make it so that business owners are protected in case of a net loss. Unlike investors, rental business owners can deduct the total loss amount instead of the capital gain rate. That being said, deducting real estate losses is only allowed in certain instances, though, so be sure to do your research.  
  • Home office deductions apply to rental business owners who often work from home. Therefore, these workers can deduct home office expenses (chairs, computers, rent, etc.) from their taxable rental income. 
  • Section 179 expensing relates to Section 179 of the tax code, which details what to do with the personal property you use in your rentals (like furniture or electronics). If you are a business owner, you can use accelerated depreciation for these items. 
  • Start-up Expenses mean rental business owners can deduct the cost of starting their business in the first year, stopping at $5,000.  

How to Qualify as A Business Owner 

So, as you can see from these deductions, it’s in your best interest to be a business owner. But how can you definitively show the IRS that’s what you are? Let’s take a look at two great methods: 

1. Three of Five Test. If you made a profit from your rental activities in three out of five successive tax years, the IRS assumes you have a profit motive. Also, the amount of profit is irrelevant. 

To classify you as anything except a business owner, the IRS would have to prove that you don’t have a profit motive. This is quite rare. 

2. Behavior Test. Another way you show the IRS you have a profit motive is through your behavior. 

Your behavior encompasses a few factors. These include well-kept records, industry knowledge, consistent and continuous work, other businesses outside of real estate, and appreciation.  

It’s important to note that the IRS will put you under a different classification if you use your properties primarily for recreation, rent at exceptionally cheap rates, or have substantial income elsewhere.  

What if You Didn’t Make a Profit this Year? 

We’ve got good news for you if the past year wasn’t the best. Even if you didn’t turn a profit, you can still qualify as a business owner. Here are a few tips for making that happen: 

  • Be sure to keep exceptional records. Save every receipt, invoice, payment, and email associated with your business. This will allow you to prove your legitimacy as a business owner should the IRS ever audit you. 
  • Log all of your time spent working. This isn’t necessarily fun, but keeping track of the hours you work will be quite useful to show that you work consistently and continuously on your rental business. 
  • Be a student of the game. Always seek out new knowledge and learn as much as you can about real estate, rental income taxes, and any other relevant information you can find. Even if you aren’t turning a profit yet, taking classes and attending seminars proves that you’re going out of your way to improve. 
  • Create a business growth plan. This is typically enough to pass the motive test because you’re showing initiative and devising a plan of action. Make sure your plan is detailed and includes elements like revenue streams, expected costs, etc. 
  • Set up a new checking account for your business. Separating your business finances from your personal finances is a good idea because it shows that you take your business seriously and expect to make money off it. It also keeps your finances organized and makes accessing reports and relevant metrics easier. 

Conclusion 

You have to qualify as a business owner to reap the benefits of deductions. So, it’s important to understand things from the perspective of the IRS. 

Motive and behavior are the keys, and as we’ve seen, the IRS will consider a wide range of activities. With this article as your foundation, you’re well on your way to saving money through taxes

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