Tax season is on the way! If you’re a newer landlord who rents a single-family home, apartment building, or vacation property, you may be wondering how to handle your taxes this year. To ensure you’re receiving the proper deductions, you’ll need to determine whether your rental property is considered an investment or a business. Here are some tips to help you decide, as well as some other helpful information about property depreciation, vacation homes, and different business structures. Please note that this is for informational purposes only and is not intended as financial or legal advice.
Investment Properties vs. Businesses
Generally speaking, any property you own and rent out is considered an investment by the IRS. Many landlords rent out properties and make a profit, but they may not be spending a lot of time working on the property. Instead, they may hire a property manager or maintenance crew to handle the everyday matters or upkeep.
This is an important distinction that sets an investment property apart from being a business—the level of time and energy you personally invest working on tasks related to the management of the property. If the rental is vacant for a good portion of the year (and you don’t spend a lot of time working on it) or you invested in it for tax purposes, it would also be considered an investment by the IRS.
However, if a landlord handles the majority of the property management themselves and is regularly spending time working on tasks for the property, it would be considered a business. This doesn’t mean that you couldn’t hire people or services to help with the property, but you would need to be able to prove to the IRS that you spent enough time working continuously at the property throughout the year to receive business-related tax deductions.
There are no requirements on the number of properties you need to own; your rental efforts can still be considered a business by the IRS, whether you have one single-family home or a 100-unit apartment complex.
What’s Considered a Residential Rental Property?
Another distinction you’ll have to make is whether your property is considered a residential rental property. Here are a couple of rules that set these types of properties apart:
- The property must be a residential dwelling unit. This means the tenant considers it home, and the property has living conditions that include a bathroom, kitchen, and bedroom. The type of property isn’t important; it could be a single-family home, a duplex, a mobile home, or a townhouse.
- The tenant living at the property must be under a lease or rental agreement.
It’s also important to note that if you have friends or family as tenants, you likely won’t get a tax deduction; for business purposes, tenants should be third-party people you’re not associated with.
What is the 80% Rule?
When determining whether your property is considered a residential rental property, you’ll also need to consider the 80% rule. The IRS classifies a property as residential if it receives more than 80% of its revenue from dwelling units.
This might seem unnecessary; chances are you’re getting 100% of the revenue from the dwelling. However, this rule is in place because some landlords may have mixed-use buildings. For example, some landlords have commercial space on the lower level and apartment space on the second level. This is most commonly found in large cities. If this applies to your property, you’ll need to make sure that 80% of your revenue from the property comes from the residence, not the commercial space. Otherwise, your property will be considered a commercial property.
There are unique circumstances to this rule as well. For example, if you own an apartment or duplex that you live at, as well as other tenants, you’ll need to make sure 80% of the rent is coming from other tenants (excluding yourself) for the property to be considered residential for tax purposes.
How to Determine Depreciation
One of the biggest tax advantages of a residential rental property is the ability to recover costs as the property depreciates. To do this, you’ll need to deduct a percentage of the cost of the property on your taxes each year. This is especially common with apartment buildings or mobile homes.
Keep in mind that you can’t factor in depreciation of a primary home—but you can depreciate items found in the home that have been in place for at least one year. This includes things like large and small appliances or furnishings (like couches or entertainment centers) if you provide them.
To determine the annual depreciation allowance of the property, you’ll need to know:
- The property’s cost basis. This can be found by adding up the total amount you paid for the property, including all fees, like closing costs and taxes. If you’ve improved the property in any way during the time you’ve owned it, this can also be added to the cost basis.
- The property’s recovery period. The recovery period is the length of time the IRS requires you to depreciate an asset. For residential properties, the recovery period is 27.5 years; for commercial properties, the recovery period is 39 years. Items within a residential unit (like furniture and appliances) have a recovery period of fewer than 10 years.
This means that if you have a residential property, you’ll be able to write it off more quickly than you would a commercial property.
How Are Vacation Homes Classified for Tax Purposes?
Whether your vacation home is considered a business depends on how many days you’ve rented it out compared to how many days your family spent there. If you’re renting out the home, you’ll want to make sure it can be considered a residential property to receive more tax benefits. Here are several situations that can apply to vacation homes:
- You never rent out your vacation home: You’re able to deduct real estate taxes and mortgage interest like you would your primary residence—but you won’t be able to deduct other things, like utilities or repair bills.
- You rent out your vacation home for less than 14 days a year: The rental income will be tax-free—and you’ll be able to deduct property taxes and mortgage interest. You won’t be able to deduct expenses related to the rental side of things, though, like repairs or trying to find renters.
- You rent out your vacation home for more than 15 days a year: The IRS would consider your rental to be a residential rental property. You’ll be required to report the rental income you received, but you’ll also be able to deduct all the rental expenses associated with the property, just as you would with a full-time rental.
5 Types of Rental Business Structures
If you intend to treat your rental property as a business, you should consider implementing a business structure. Here’s an overview of the 5 different types of business structures you might have as a landlord:
- Sole Proprietorship
Sole proprietorships are one of the most common types of business structures. In a sole proprietorship, the business is owned by a single individual or married couple. It’s the easiest type of business to operate, and many people find it less confusing than other business structures. There are fewer legal controls and taxes involved, but on the flipside, sole proprietors are personally liable for debt incurred by tenants or the business itself.
- General Partnership
A general partnership is usually owned by at least two people (who aren’t married) who agree to have equal responsibility with the business. This means they share financial responsibility, like expenses, as well as management responsibility and labor. If any debts are incurred, each person is individually liable—so make sure that if you have all the details clearly laid out in writing if you choose this type of business structure.
An estate is similar to a sole proprietorship, but a business can only be considered an estate when the property’s owner passes away. The property may be granted estate status to allow the business to continue running under the new owners until all the legal issues are addressed. Depending on how long this takes, a property may be considered an estate for an extended period of time.
- Limited Liability Company (LLC)
An LLC is created by one or more individuals through a written agreement, which details everything regarding the operation of the company, such as management, tasks, and the distribution of income or losses. It’s considered a type of “pass-through” entity, meaning that it’s not a corporation and all earnings are passed through to each of the members, who are responsible for their own self-employment taxes. A benefit of LLCs is that they can help protect an individual’s personal assets if the property runs into legal or financial trouble. For example, if a tenant was injured on your property and decided to sue, they would be suing the LLC, and your personal assets would be protected from the associated risk. To become an LLC, you need to file with the Secretary of State in the state where the property is located.
- Tenants in Common
Tenants in common is a lesser-known type of business structure that allows two or more people to occupy the same property while keeping the property’s assets and liabilities completely separate. Tenants in common can have varying shares in the property, but all co-owners have the same right to enjoy the entire property.
Owning a rental property can be a lot of work—it can also have important financial implications come tax season. Hopefully, this guide has helped you understand how to classify your property so you can receive the appropriate benefits and some of your different options should you decide to turn your investment into a business. To ensure nothing gets overlooked, it’s always a good idea to consult with a professional tax preparer or CPA who specializes in real estate.
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