If you’re a landlord that rents out a single-family home, a large apartment building, or even business space, you’ve likely wondered if your rental property is considered a business come tax time. It’s important to know that there are two classifications when it comes to rental property and taxes. You need to know this information so you can properly get your tax deduction when the time comes.
Below we’re going to talk about how to know whether or not your property is considered a business, different types of business structures for landlords, and more. Keep on reading to get the most money back come tax time and learn a bit about whether or not your property is a business.
Table Of Contents For Whether A Rental Property Is A Business
- Rental Properties That Are Investments
- Rental Properties That Are Businesses
- What Is Considered A Residential Rental Property?
- The IRS 80% Rule
- Depreciation Of Residential Rental Properties
- Are Vacation Homes Considered Businesses?
- Different Business Structures For Landlords
- Tips For Making Your Rental Property A Business
In general, owning property that you rent out is an investment. This is because you may earn a profit but don’t necessarily work at the rental property. Oftentimes landlords will hire help such as property managers or maintenance crews.
If you have a property that you rent to a tenant and you use the income to pay bills relating to that property, you may find that you, in fact, have an investment, not a business, according to the IRS.
Although it’s important to note, and you’ll read later on, that renting a property can be a business. You need to prove to the IRS that your management activities are continuous throughout the year and done often enough to show that it’s a business rather than an investment.
If you rent out a house to a tenant and you take on the management position where you’ll need to do things like replace a water softener or fix something that’s broken, you’re more likely to be considered a business.
It’s also important to note that if you have a rental property that has been vacant for a long time or becomes vacant more often than not, the IRS may consider that specific property an investment because you don’t spend a lot of time working on the property or with a tenant that lives there.
Lastly, if you’ve invested in a property for tax purposes and aren’t continuously involved in management duties, the IRS will consider this an investment. This can include limited times partners, real estate investment trusts, and people who own shares
As you’ve probably gathered from what you’ve read above, when you own a property, it will qualify as a business if you earn profit and regularly work at the property.
Let’s say you own four apartment complexes. These complexes have several tenants and you can often be found working at the units. This can include office work such as finding new tenants, posting advertisements of empty units, or physical work such as putting in new furnishings, cleaning empty units, and looking at maintenance requests from renters.
You’ll probably like to hear that you don’t necessarily have to do all the work yourself for your property to be considered a business by the IRS. You can hire people like a property manager or maintenance employees to help you.
If you don’t have the time to manage the four apartment complexes as you have, by all means, you can hire a real estate agent or property manager to help you out. If you have someone working for you, even if you’re not at the property that often, the property can still be considered a business.
Thankfully, there isn’t a specific number of properties you have to own in order to qualify as a business. Whether you rent out one single-family home, 10 apartment complexes that are used for student housing, or you own a strip of business spaces that a store rents, you may be considered a business by the IRS.
If you’ve bought a home or property that you rent out to tenants, then you’re likely dealing with a residential rental property. Here are a couple of rules that set apart residential rental properties from other types of properties.
The property you’re renting out has to be a residential dwelling unit. This means that someone lives there and considers the space their home. The type of property doesn’t really matter. It can be a single-family home, an apartment unit, a duplex, a mobile home, or a townhouse. If the property has living conditions such as a bathroom, kitchen, and a bedroom, then it is technically classified as a residential rental property.
The other rule that you must follow in order for your property to be considered a residential rental property is that whoever is living there must be under a lease or rental agreement. It’s important to note that if you have friends or family that are tenants, you likely won’t get a tax deduction. Make sure your tenants are third-party people that you’re not associated with so you can get all of the tax deductions that you’re owed.
Taxes can be confusing for everyone, especially property owners. The language of the IRS can be complicated and overwhelming to understand. It’s important to know that the IRS considers a property residential if it gets more than 80% of its revenue from dwelling units.
The IRS 80% rule may seem unnecessary to most landlords. This is because chances are you’re getting 100% of the revenue from the dwelling itself.
The reason the IRS has this rule is that some property owners have mixed-use buildings. This is often found in larger cities where you’ll find apartment buildings on top of businesses that are all inside the same building or on the same property.
This is where things can get complicated. If you have a coffee shop on the first floor of the unit followed by three apartment units on top of the coffee shop, you have to make sure that 80% of your monthly rental income is coming from the residence, not the coffee shop. If this isn’t the case, the property will be considered a commercial property rather than a residential rental property.
There are also unique circumstances, especially with duplexes and apartments, where the owner lives on site. If you rent out a duplex or apartment building and live in one of the units, you have to make sure but 80% of the rental income is coming from the other tenants, excluding you.
One of the main tax advantages you have when you own a residential rental property, is being able to recover the cost of the property as a capital expense by depreciating the property. This is done by deducting a percentage of the cost every year on your tax returns.
As you can probably guess, this is more popular with people who own mobile homes or apartment buildings. It’s important to note that you can’t depreciate a primary home, but you can depreciate things that are found inside the rental property that have been there for at least a year. This can include appliances such as refrigerators, microwaves, dishwashers, or even furniture such as couches or entertainment centers.
So, how are you supposed to determine the annual depreciation allowance of your property? The best option would always be to hire a professional accountant or CPA. You want to have an expert handle your taxes not only to stay on the safe side when it comes to the IRS but also to utilize legal tax-saving benefits available to landlords.
However, instead of choosing a professional that serves all sorts of businesses, opt for CPA firms specializing in real estate. You want your CPA to know all the particularities of your business inside out. Only then you can take full advantage of your rental business. That said, if for some reason you don’t want or can’t hire a professional, you’ll need the two things listed below.
You need to know the property’s cost basis. You can find this by adding up the amount you paid for the property, including closing costs and all legal fees and taxes. If during the time you’ve owned the property you’ve improved it, whether that’s remodeling or adding onto the property, you can add that cost to your tax basis.
The other thing you need to know about is the recovery period. Over time, residential rental properties will depreciate with a recovery period of just over 27 years. For non-residential rental properties, depreciation will take place over nearly 40 years.
This means you’ll be able to write off the entire property much quicker when it is a residential rental property rather than a non-residential rental property. When it comes to the items within the unit such as appliances and furniture, they have a recovery period that is less than 10 years.
Some readers may be wondering if their vacation homes that they rent out are considered businesses. This can depend on how many days your vacation home is rented out in correlation to how many days you and your family spend in the home. When you’re renting out a property, you want your vacation home to be classified as a residential rental property to get more benefits when tax season arrives.
If you have a vacation home that you never rent out, you can still deduct real estate taxes and things like mortgage interest just like you would your everyday home. Unfortunately, you won’t be able to deduct things like repair bills or utilities.
If you rent out the vacation home for less than 14 days in a year, you’ll be able to take the rental income tax-free and still be able to deduct the property taxes and mortgage interest. One way this differs from when a rental property is considered a business is that you won’t be able to deduct any expenses that are associated with the rental such as trying to find people to rent it out.
But what if you rent out to your vacation home for more than 15 days in a year? If this is the case, the home is then considered a residential rental property according to the IRS. This means you have to report the rental income you get from the people renting out your vacation home to the IRS. The nice thing about this is that you’ll be able to deduct all rental expenses that are associated with the home, just like you would if you were to rent out an apartment building.
We here at RentPrep understand that knowing the different business structures for a rental property can be confusing. We wanted to lightly touch on a few of the different types of business structures that you as a landlord might have. Let’s take a look.
A sole proprietorship is one of the most common types of business structures. This is when a single individual owns a business or a married couple are in business together. This type of business is the easiest to operate and it may be the least confusing of the bunch.
There are fewer legal controls and fewer taxes involved with a sole proprietorship. With that being said, it’s important to note that the business owner will be personally liable for any debts that may be incurred by the tenants or business associated with the owner.
Next, you have a general partnership. This is usually composed of at least two people who are not married but agree to bring money, labor, or skills to the table. Anyone involved will share the profits, losses, and management duties. This also means that each person is individually liable for any debts that may incur. If you’re considering a general partnership, make sure that you have all the details in writing.
An Estate business structure is similar to a sole proprietorship. The main difference is that a business structure is considered an estate when an individual owner passes away. Because of legality or operations of the business, the property may go into an estate status so that the property or business can continue running under the current owners until all legal issues have been addressed. It may benefit you to know that a property may be in an estate status for an extended period of time.
Limited Liability Company
A limited liability company, also known as an LLC, is generally formed by one or more individuals through a written agreement. The agreement will detail everything to do with the LLC, including income, management, tasks, and distribution of income or losses. It’s important to note that LLCs are permitted to take part in any lawful activities with the exception of banking or insurance. In order to become an LLC, you have to file with the Secretary of State where the property is.
Tenants In Common
Lastly, we wanted to touch on a business structure that’s not often talked about. Tenants in common is a business structure that lets two or more people occupy the same property while having completely separate identities when it comes to assets or liabilities from the property.
We wanted to include a few tips that can make turning your rental property into a business a little easier. The first few tips are in relation to using the safe harbor, and the rest will make the entire process a little less stressful.
1. The first tip is that you should maintain separate books and records for every rental property you have. This means that every house, duplex, or apartment should all have their own records associated with the property.
2. As you read above, in order for a rental property to be considered a business, you need to actively be working or maintaining the property. With that being said, there needs to be at least 250 logged hours of maintenance or rental services each year that were performed by you or an independent contractor.
3. It’s also incredibly helpful to not only maintain records, but also time reports or any documents that show the number of hours you’ve serviced to the property, a description of all the services you’ve done, the date and time on which the services were completed and who, if not yourself, completed the services.
4. Another tip is that you may want to look into learning a little bit more about is real estate and business. There are plenty of online or in-person classes that can teach you new things that may benefit you in the long run.
5. If you’re new to owning property and don’t have much experience in the business world, you may want to partner up with somebody. It is advised that you don’t partner up with a friend or family member as this can create tension and could end up ruining the relationship. Consider partnering with someone who has strengths where you have weaknesses and knowledge where you are naive.
6. Our sixth tip is to get help. While you may be required to put in a specific amount of hours at the property for it to be considered a business, you can hire people, such as property managers and maintenance employees, to help make the job a bit easier. As long as these people are working for you, you can still claim the property as a business.
We understand that owning a rental property is a lot of work. It can often consume your life and be a lot more complicated than you initially thought. When you add a business aspect into that, things can get even more confusing. Hopefully, this guide will help you understand when your rental property is considered a business according to the IRS and, if not, how to turn it into one.
You’ve learned the difference between rental properties that are businesses and rental properties that are considered investments. We also touched a bit on the IRS 80% rule – that’s incredibly important to know if you’re a property owner. Remember to consider things such as depreciation, the amount of time you need to work on a property for it to be considered a business, and all of the different types of business structures.
We hope that all the information given to you above will not only help you create a business out of your rental property but bring you a lot more money come tax time.
When you’re ready to explore your rental property as a business, check out this video of how to put together a plan: