Real Estate Rental: Is Your Property a Business or an Investment?

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If you own rental real estate that generates income through the year, one of the most important tax issues to consider is whether the rental activity is classified as a business or an investment. Being classified as a business is ideal because there are major tax savings via a pass-through income tax deduction of up to 20% of net rental income (currently valid 2018 -2025), but in order to maintain that classification, there are standards to follow.

Rental Activity Classified as a Business

Generally, if you own a rental property, it can be classified as a business if you 1. do it to earn a profit and 2. work at it regularly and continuously.  Since this is a bit vague, the IRS graciously provided Revenue Procedure 2019-38 to establish a safe harbor to help you determine if your rental activity is sufficient to redeem the 20% rental income tax deduction. Here are the guidelines to follow:

Maintain the Books

You have to maintain separate books and records for each* rental property owned.

250 hours

You should perform at least 250 hours of rental services per year (or if this is a property you've had for 4+ years, then 250 hours for 3 of the last 5 years).

Keep Logs

You have to keep logs, time reports, and/or other monthly/annual records detailing any services performed.

File Paperwork

You must file all required information and/or returns required.

This is all easy enough, and more good news is that there is no specific number of rental properties or rental units you must own for your rental activity to qualify as a business – you can even be a part owner! And if you don’t have the time to devote 250 hours or keep up with the paperwork? That’s ok too! The IRS says you can hire employees or contractors and their time worked will be included in the 250-hour minimum. 

*If you do own several properties, generally, the rule is to either treat each rental property as a separate enterprise or treat all similar properties as a single business. For instance, commercial and residential properties can’t be combined in the same business.

Rental Activity Classified as an Investment

Now that you know about a sizable deduction and can see the ease of being classified as a business, you may wonder “how is it even possible to classify a rental activity as an investment?” Well, let me give you three examples of how this could easily happen to you.

Suppose you bought or inherited a home and over the years, you’ve simply rented it to the same person/family. You collect payments from the tenant and when an issue arises, either you or your tenant takes care of it, but there is no other oversight or management.  In this scenario, you are not searching for tenants or engaging in any property management, so your activities as a landlord do not meet the requirements to be classified as a business.  Note: This is not to say ALL long-term rentals function in this manner – it is simply an example.

In commercial rental agreements, there are several contract options called “net” which require the tenant to pay rent as well as other expenses.  Under a triple net (net-net-net or NNN), the tenant is required to pay rent and all additional expenses including taxes, insurance, maintenance, and other expenses. Generally, that means and all you do is cash the check – and thus it is not enough to be classified as a business activity for you.

And of course, if you purchase interests in business entities that own real estate, but you are not actively involved in the management of those entities, you’re involvement is classified as investment rather than business. This generally also includes the limited partners in limited partnerships and people who own shares in corporations and real estate investment trusts.

Rental Business vs. Real Estate Professional

Real estate is a tricky “business” to be in.  You can meet the criteria above for certain deductions, but this  does not qualify you for the business-related deductions allowed for business owners – such as the ability to deduct losses against wages or other ordinary income.  This is because of a unique material participation rule that doesn’t apply in most other professions.

Material Participation vs. Passive Activity: In general, if you are a business owner, you have to prove “material participation” to the IRS.  Material participation is met when you can show you spent 500 hours per year on the activity, or more than 100 hours and no one else participates more.  Anything less is considered to be a “passive activity”.

Real Estate Professional Material Participation: To qualify as a “real estate professional” (which is considered a business owner), you must spend at least 750 hours per year AND more than half of your total working hours on real estate businesses.  This can include development, construction, leasing, brokerage or management.  Additionally, the hours you spend as an employee don’t count unless you own at least 5% of the business.

Real Estate CPA

Avizo Group specializes in working with real estate owners, investors, and professionals. We can guide you through complex tax laws as well as help you identify opportunities to expand. View our Real Estate page and contact us by clicking the button below if you would like to learn more.

Allen Cave, CPA | Shareholder & Strategic Consultant

With 20+ years experience in developing complex compliance & planning strategies, Allen specializes as a business consultant for our retail and real estate niches. 

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