When It Comes to Taxes, Is Managing Rental Properties a Business or an Investment?

Whether you are the landlord of a single-family rental or you own a share in a large apartment building, it’s essential to know how to classify this activity at tax time. 

Are you an investor or a business owner?

In this article, we’ll examine the distinction between the two and how qualifying as a business owner can save you money in deductions.

Rentals that qualify as a business

Your rental activity qualifies as a business under the law if you can prove your rentals are “for-profit” and that you work at this business “regularly and continuously.”  

Landlords can hire managers and contractors to do most of the work on their property, but they still must be engaged in running the rentals, according to the law. Also, if a rental unit is vacant, it doesn’t preclude you from qualifying as a business owner -- as long as you are marketing the space for rent.

Here are other factors the IRS uses to determine if your rental activity is a business:

• the type of rental property you own—commercial versus residential
• the number of properties you rent out
• your or your agent’s involvement
• the lease terms – such as whether it is a short-term or long-term lease
• the types of ancillary services provided under the rental agreement
• whether you have filed all required forms

Here are some other ways you can prove you are operating a business with your rental property:

The ‘three of five years’ test

If, as a landlord, you have earned a profit in three of the past five years, the IRS sees you as a business. If you cannot meet this requirement, you must pass the “behavior” test.

The behavior test

You can operate rentals at a loss every year and still qualify as a business owner if you meet the behavior test criteria. Here are the factors an IRS auditor will use in this case:

• Operations. Are you operating as a business would?
• Expertise. What is your knowledge of real estate?
• Time and effort. How much of your time do you devote to being a landlord?
• Experience. How long have you been in the business, and what is your track record?
• Money management. What is your profit/loss history?
• Appreciation. How has the value of your property fared over the time you’ve owned it?
• Your net worth. What other income and assets do you have?
• Your lifestyle. How do you spend your time when you are not working as a landlord?

In order to pass the behavior test, you need to maintain excellent records, including a time log of all your real estate activities. You can establish your expertise through references, blogs, speeches, and podcasts.

Rentals that do not qualify as a business

Landlords often do not qualify as business owners when they do one or more of the following:

• buy and hold land for future sale
• passively invest in mortgage notes
• invest as an LP (limited partner) in real estate syndications
• have a small portfolio of rental units that are either leased out and don’t require much management
• own triple net lease properties

What you gain as a business owner versus an investor

For tax purposes, it’s always better for your rental activity to be a business rather than an investment. As a real estate business owner, you can deduct the following:

• start-up costs
• home office expenses
• passive losses from real estate
• fees and costs for attending conventions and seminars
• IRS Section 179 expenses

Landlords who meet the criteria of being business owners may qualify for the pass-through income tax deduction of up to 20% of their net rental income from 2018 through 2025.

This deduction—which is also called the Safe Harbor Rule—is part of the Tax Cuts and Jobs Act (TCJA), the tax reform package that became law in 2018. The deduction will end on January 1, 2026, unless Congress votes to extend it.

Use of the safe harbor rule is optional. To qualify for this deduction, a landlord must:

• perform a minimum of 250 hours of real estate rental services each year (including work by employees and agents)
• maintain records that document these real estate rental services
• keep separate records showing all income and expenses for each rental enterprise.

Landlords who use their rental property as their residence for more than 14 days during the year are not eligible for the Safe Harbor Rule. This requirement means that most short-term rental hosts may not apply for the deduction.

Finally, we cannot emphasize enough the importance of record-keeping as a landlord. Accurate, well-organized records will help you manage your rental property, prepare your financial statements, keep track of your expenses, prepare your tax returns, and support the items you report on your tax returns.