Tax season is a dreaded time of year for landlords, and for good reason.
Rental property taxes are some of the most complex and confusing there are.
While it’s not your job to understand the entire tax code (unless you want to), understanding even a little about how your accountant or software application prepares your taxes can benefit you immensely when it’s time to file your tax return. You can easily miss great deductions if you don’t know they exist.
The landlord tax classifications are a good place to start learning about rental taxes. According to the IRS, your rental activity can fall into one of three classifications. The IRS treats each classification differently, and the best deductions are only available to those landlords classified a certain way.
Your classification is up to you initially, but the IRS may audit you to reassess your choice.
Below is a brief overview of the three landlord tax classifications and their implications for your taxes.
Most landlords are business owners. This classification is the best for tax purposes because it allows you to claim the most deductions and maximum tax refund.
Business owners actively and consistently engage in rental activity to make a profit. Both behavior (regular and consistent engagement) and motive (profit) are key to this classification. However, you may hire a property manager to do the management work on your behalf and still qualify as a business owner.
Other than these two criteria, the IRS does not set a minimum number of properties or working hours to qualify. Instead, the IRS tends to consider both facts (number and type of properties) and circumstances (level of involvement, behavior, and motives).
Safe Harbors and Tests
The IRS does provide a few objective tests for determining and proving your classification. First, you may use the optional safe harbor for working hours. Safe harbors are provisions that allow you to automatically qualify for certain deductions if you meet a minimum.
For example, if you work at your rental activity at least 501 hours per year, you are automatically a business owner should you opt to use the safe harbor.
Additionally, you may use the Three of Five test: If you made a profit in three of the last five consecutive tax years, you are automatically a business owner.
Business owners have by far the most opportunities and deductions granted by the IRS. If you pass a safe harbor, the Three of Five test, or the behavior test, you have access to many great deductions, including:
- Pass-through income
- Real estate losses
- Home office
- Start-up expenses
- Section 179 expensing (for personal property)
Like a business owner, an investor owns property or a portion of property. However, investors are only passive owners and are not involved in the day-to-day management of tenants or properties.
For instance, let’s say you receive property as an inheritance from a family member. You own the property, but if you aren’t actively renting it out to tenants or preparing to, you are only an investor.
Likewise, you are also an investor if you own a unit but have an agreement where the tenant manages maintenance and care of the property.
Investors can use some rental deductions but not as many as business owners.
The final landlord tax classification is the not-for-profit owner. Your rental activity is not-for-profit if your motive is anything other than profit (charity, recreation, etc.)
For example, let’s say you own beach-front property in Florida. If you primarily use this property as a family vacation home throughout the year, your motive isn’t profit, and you are therefore not-for-profit in the eyes of the IRS.
The IRS also considers you not-for-profit if you rent at below-market rates as a favor to someone or if you have long-term vacancies that you make little effort to fill.
Not-for-profit is the worst classification for tax purposes because you cannot deduct any rental expenses. Even if you spent hundreds or thousands of dollars on maintenance throughout the year, you can’t deduct any of those expenses, and you’ll still have to pay tax on all your income.
Understanding Rental Taxes
Now that you understand the three landlord classifications, you can focus on qualifying as a business owner. The importance of keeping good records cannot be understated. By keeping written records of your time and effort spent managing your rentals, you’ll have no problem qualifying as a business and achieving the best deductions