Today I am starting a series of articles that I have titled RETAX, and where I will explore the most relevant tax issues that real estate owners face. The tax code as it relates to real estate is quite complex, so my goal is to broaden the understanding of these complex topics for those that own real estate. Today’s topic is a fundamental part of the tax code as it relates to real estate: Landlord Tax Classifications.
Tax Classifications
First, a point of clarification. In this article, the term “real estate owner” refers to those who own real estate for non-personal use purposes, renting the property to third parties and collecting rent. There are three tax classifications for real estate owners, as follows:
- business owner
- real estate investor
- not-for-profit
It is the behavior of you as the owner that determines your tax classification. and this classification can have a significant impact on the taxes that you pay. Below I will provide you with an overview of each classification, from best to worst.
Business Owner
This classification is the best for the landlord, as it provides several tax deductions that are not otherwise available to real estate investors. These deductions include the following:
- Home Office Expense – Do you use a space in your home that is dedicated to your work on rental properties? If the answer is yes, and you are classified as a business owner, you can take a deduction on your tax return for the expenses related to your home office. However, the rules for this deduction have some complexities, so you may want to seek the advice of a tax expert to make sure you qualify for this deduction.
- Start-Up Expenses – Business owners are allowed to expense up to $10,000 in start-up expenses and $5,000 in organizational costs in the year the business is started. See IRS publication 583 for more details.
- Section 179 – IRS code section 179 allows a business to expense certain equipment, furniture, and fixtures in the year acquired instead of depreciating these assets over their useful life.
- Pass-Through Deduction – Businesses are allowed a tax deduction of up to 20% of their net rental income.
The key determining factor in determining whether you are a business owner rather than an investor is whether you, as landlord, are actively running a business. Therefore, to qualify as a business owner, you must be striving to earn a profit and work at it regularly and continuously. The IRS provides a list of factors that are to be considered in determining whether you are a business owner, as follows:
- the type of rented property (i.e. commercial or residential)
- the number of properties rented (although in certain cases one property has qualified as a business)
- the owner’s (or owner’s agent’s) day-to-day involvement
- the types and significance of any ancillary services provided under the lease
- whether the landlord has filed all required information returns, such as form 1099-NEC
There is no minimum number of hours that have been set by either the IRS or the courts. However, the IRS has issued regulations that establish optional “safe harbor” rules that do establish minimum hours for landlords for certain situations, as follows:
- 500 Hours – Net Investment Income Tax (NIIT) – As long as a real estate professional devotes a minimum of 501 hours each year to the rental property activity, this activity will qualify as a business for purposes of the NIIT, and the income will not be subject to NIIT.
- 250 Hours – Pass-Through Deduction – The IRS assumes that the rental activity is a business for this deduction if the landlord spends at least 250 hours per year working on the rental activity.
Since these are safe harbor rules, a taxpayer can work less hours than this and still qualify as a business, depending on the specific circumstances. Also remember that these safe harbor rules are only to be used for these specific deductions, although if the taxpayer were to be audited, adhering to these would be a strong argument for overall qualification as a business.
Real Estate Investor
If you only own one or a few properties and you spend a minimal amount of time on them, then you are a real estate investor instead of an owner. There are a couple of situations that may make it more difficult for a landlord to qualify as a business owner, resulting in being classified as a real estate investor:
- Your tenants are stable, your properties are well-maintained, and therefore there is little demand on your time to manage these properties.
- You have commercial properties with triple-net leases, where the tenant is required to manage the property and pay the taxes.
- You rent the property only to family and/or friends.
- Your property is vacant for a significant amount of time.
Not-For-Profit
If you lack a profit motive for your real estate investments, the IRS may claim that you are a not-for-profit entity. Quite frankly, this is a tax disaster, as all of your revenues are taxable income, while you are not allowed any deductions to offset this income. So you should avoid this classification if at all possible. The easiest way to avoid this is to be profitable in your rental business.
There are three common situations where you are more likely to be at risk of being classified as not-for-profit, as follows:
- You rent a vacation home that your family also uses
- You rent your property at rates that are below the market
- Your property sits vacant for long periods of time
Other than in these situations, it is not usually too difficult to prove you have a profit motive. There are two tests that the IRS uses to determine if there is a profit motive, as follows:
- Three-of-Five Test – If you earn a profit from your rental activity in three of the past five years, the IRS presumes that you have a profit motive. However, if they discover you have manipulated the financial numbers to meet this test, then this could be (and likely will be) challenged.
- Behavior Test – If you engage in your rental business primarily to earn profits, you may still have a profit motive even if you continually have losses. The IRS will look at several factors to determine if your behavior aligns with someone who wants to earn a profit, as follows: 1) how the activity is carried on; 2) your expertise; 3) the time and effort you spend; 4) your track record; 5) your history of income and losses; 6) your profits; 7) appreciation; 8) your personal wealth; and 9) elements of fun or recreation.
To pass the Behavior test, there are things you can do to support that you are seeking profit. This is especially critical if you have a history of losses on your rental properties. If this is the case (and even if it isn’t), following these steps are a good idea to keep you out of trouble with the IRS:
- Keep good business records
- Keep a separate checking account for your rental property business
- Keep track of the time you spend working on your rental properties
- Expend effort to rent your properties
- Establish and document your expertise
- Show evidence that you anticipate your property will appreciate in value
- Prepare, maintain, and regularly update a business plan that shows how much you expect to earn over the time you expect to hold the property, including profits and cash flows
As these rules are quite complex, seeking a tax advisor who is up-to-date on these rules is a must for most real estate owners. At The Seay Firm, we specialize in the real estate and construction industries, so give us a call if you would like to set up an initial consultation. I can be reached at (479) 876-9980, ext. 102 or at Brent@seaycpas.com.