The distinction between rental activity as a business or investment has tax consequences. Qualifying as a business rather than an investment is better for tax purposes. As a business owner, you will receive tax deductions that do not apply to investors. Here are some basics you need to know.
Rental activity as a business
When you own rental property, it qualifies as a business if you make a profit from it and work at it regularly and continuously. For a rental property to qualify as a business, you need to demonstrate to the IRS that you perform management duties throughout the year.
There are no requirements about how many properties you need to own, and you don’t necessarily have to do all the work yourself. You can hire a property management company to manage a property for you, and it is still considered a business.
Evernest, Boom properties and Fowler offer Boulder property management consulting. The experts will do management duties for you, such as finding suitable tenants, collecting rent, and doing regular maintenance. You will receive reports that will help when preparing tax returns.
Rental activity as an investment
Owning a rental property is considered an investment rather than a business if you don’t work at it regularly and continuously. Landlord activities may be too minimal in such a case to rise to the level of a business. Courts have determined that landlords aren’t in business when they only rent out their property to family or friends. If a property is vacant most of the time, the IRS could decide you are an investor because you don’t spend much time dealing with the property.
When investing in properties outside of your local area, it may be more challenging to demonstrate to the IRS that you are actively involved in managing the property from afar. However, you may still qualify as a business if you hire a property management company to handle all the day-to-day tasks. So, even though investing in rental properties in other cities may seem daunting, it is not impossible. With the help of technology and professional property management services, managing your rental from afar and qualifying as a business is now a viable option.
The IRS 80% rule
The IRS requires that a property gets more than 80% of its revenue from dwelling units to consider it a residential rental property. If you reside in a duplex and rent out to other tenants, you need to make sure that 80% of the revenue comes from the other tenants. If you own a mixed building in a large city, with a store on the first floor and rental units above it, you must receive 80% of your income from the rental units or the property is considered a commercial property.
Depreciation of rental properties
One of the advantages of owning a residential rental property is that you can recover the costs of the capital expense by depreciating it every year on your tax returns.
To do this, you need to know the cost basis of the property. This means adding up what you paid for the property, including legal fees, closing costs and taxes. You must include any improvements or remodeling you’ve done to the property since owning it.
You also need to know the recovery period. The general recovery period for residential rental property is 27.5 years. Non-residential properties depreciate over many more years, so they take longer to write off. Items in a rental unit, such as appliances, have a recovery period of less than ten years.
The different structures available for landlords
In addition to different rental property classifications, there are also different business structures available for landlords.
Sole Proprietorship: This is an easy-to-operate, simple business structure. A sole proprietor runs the business and is personally responsible for any debts incurred.
General partnership: Partners can agree to work together and share the management duties, profits and losses. It’s important to have all the partnership details in writing, as each partner is individually liable for debts incurred.
Estate: A sole proprietorship can become an estate when the business owner passes away. A property may go into estate status for sorting out legal issues.
Limited Liability Company (LLC): One or more individuals can formalize their business association with a written agreement. This agreement typically outlines factors such as income, management, and distribution of income or losses.
Tenants In Common: This structure allows two or more people to own the same property but have separate assets and liabilities.
Tips for making your rental activity a business
If you want to make sure your rental property is classified as a business, there are some tips that can make it easier.
- Keep separate records for each rental property.
- Keep logs of at least 250 hours of maintenance or services that show you are actively working at the property. Include dates and times when services were completed and who completed them.
- Consider benefiting from the expertise of those who have experience in areas where you don’t, such as property managers.
When your rental activity qualifies as a business rather than an investment, it offers you a number of advantages. Hopefully, the above facts have given you more idea of how properties are classified and what you need to do to make sure your rental property qualifies as a business.