Whether you’re the landlord of a single-family home or you own a multi-unit apartment building, it’s important to understand whether your rental is considered an investment or a business because the distinction can have important tax consequences. If you’re considered a business owner, you’ll receive valuable tax deductions that don’t apply to investors. With tax season on the way, it’s an ideal time to revisit how rental properties are classified and some of the requirements you’ll need to know about if you’d like to turn yours into a business. Please note that this is for informational purposes only and is not intended to provide legal advice.
Investments versus Businesses
Typically, rental properties are considered investments by the IRS. This is because you may make a profit from the rent, but you don’t necessarily spend time working at the property. It’s essentially passive income. If you use the rent money from the property to pay for bills related to the property, the IRS considers it an investment.
However, even though many rental properties are considered investments, they can be businesses. For example, if you take on the management of your property where you’re regularly making repairs or replacing appliances, it’s more likely considered a business. If you own and manage a rental that’s been vacant for a long time or only has occasional occupants (like a vacation rental), the IRS may consider it an investment because you’re likely spending less time working at it. Likewise, properties that involve limited times partners, real estate investment trusts, and time-shares are considered investments.
In order for your rental property to qualify as a business, you’ll need to show the IRS that you have been performing management duties continuously throughout the year. You don’t necessarily have to do all the work yourself either; you can hire property managers or maintenance employees to assist you with office work, marketing, maintenance requests, and other day-to-day tasks and the property will still be considered a business.
There are no requirements on how many properties you need to own to qualify as a business; it can be a single rental home, multifamily homes, or even a commercial space that a store rents.
What is a Residential Rental Property
It’s also important to know that residential rental properties have some additional rules that set them apart from other types of properties. To be considered a residential rental property, the property must be a residential dwelling unit. This means someone lives there and considers it their home. It can be a single-family home, a duplex, a townhouse, an apartment unit, or even a mobile home, as long as it has living conditions like a bathroom, kitchen, and bedroom. The second rule is that you must have a lease or rental agreement.
Friends and family living at the property likely won’t be considered tenants for business purposes by the IRS, so if you’d like to take advantage of tax deductions, you’ll want to make sure your tenants are third-party people that you’re not otherwise associated with.
The 80% Rule
To be considered a residential rental property, the IRS also requires that the property gets more than 80% of its revenue from dwelling units. This may seem unnecessary, as most landlords probably receive 100% of the revenue from their units, but some property owners have mixed buildings, particularly in larger cities.
Your property could consist of a convenience store on the first floor with a handful of apartment units above it. In this case, you’d have to receive 80% of your income from the rental units for the property to be considered a residential rental property; otherwise, it would be considered a commercial property.
The 80% rule also applies to duplexes and apartments where the landlord is also residing. In this case, you’d need to make sure that 80% of the revenue coming in is coming from the other tenants in the building (excluding yourself).
Depreciation Tax Breaks
A large advantage to owning a residential rental property is that you can recover the cost of the property as a capital expense by depreciating it each year on your tax returns. Although you can’t depreciate a primary home, you can depreciate appliances, furniture, or other things inside the home.
To determine your annual depreciation allowance, you’ll need to know the property’s cost basis and the recovery period. You can find the cost basis by adding up what you paid for the property (including closing costs, legal fees, and taxes) as well as any improvements or remodeling you’ve done to it in the time you’ve owned it.
Over time, residential rental properties depreciate with a recovery period of just over 27 years; this is in contrast to non-residential rental properties, which depreciate over about 40 years. What does this mean for you? You’ll be able to write off residential properties quicker than a non-residential rental property. Items in the unit like appliances have a recovery period of fewer than 10 years.
Different Business Structures
In addition to different classifications for your rental properties, there are also different business structures for landlords:
- Sole Proprietorship – This is one of the most common types of business structures, as well as the easiest to operate. A sole proprietorship is when an individual (or a married couple) runs the business. Although there are fewer legal controls and taxes, sole proprietors are personally liable for any debts incurred by tenants or the owner’s business.
- General Partnership – A general partnership is made up of at least two people (who aren’t married) who agree to work together and share the profits, losses, and management duties of the business. Typically, each person is also individually liable for any debt that incurs, so make sure to have all the details of your partnership in writing.
- Estate – An estate business structure is similar to a sole proprietorship, except that becomes an estate when an individual owner passes away. Due to the legal issues or the operations of the business, the property may go into estate status so that the property or business can continue running until the legal issues have been addressed.
- Limited Liability Company – Also known as an LLC, a limited liability company is typically formed by one or more individuals through a written agreement that outlines income, tasks, management, and distribution of income or losses. LLCs can engage in any lawful business activity except for banking or insurance. To become an LLC, you’ll have to file with the Secretary of State where the property is.
- Tenants In Common – This is a business structure that allows two or more people to own the same property while having separate assets and liabilities for it.
Tips for Turning Your Rental Property into a Business
Have you decided you want to turn your rental property into a business? Here are a few tips that can make the process a little easier.
- – Keep separate books and records for every rental property you have.
- – Log at least 250 hours of maintenance or rental services each year that were performed by you or an independent contractor; this shows that you’re actively working at the property.
- – Keep time reports or any other documents that show the number of hours you’ve worked on the property, all the tasks or services you did, the date and time that the services were completed, and who completed them (if you hired someone).
- – Consider taking a real estate and/or business class.
- – If you’re a new landlord or you don’t have much business experience, you may want to consider getting a partner; however, you may want to avoid partnering with friends or family, as that can cause tension in your relationship. Find a partner who has experience in the areas you’re lacking.
- – Hire help, like property managers or maintenance employees, to make your job a little easier.
Owning a rental property can be a lot of work and turning it into a business can definitely make things more complicated. Hopefully, this guide has given you some clarity on how your property is classified and how to turn it into a business – if it’s not already.
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