It's to landlords' advantage tax-wise to categorize their rental activities as a business, not an investment.
Whether you rent a single-family house or a multi-unit apartment building, one of the most important tax issues landlords must deal with is whether your rental activity qualifies as a business or an investment for tax purposes. This distinction between the two classifications has important tax consequences. If, like most landlords, you are a business owner, you get certain valuable tax deductions that investors can't use (including the home office deductions, start-up expenses deductions, and Section 179 expensing). Most notably, landlords who are in business may qualify for the pass-through income tax deduction of up to 20% of their net rental income during 2018 through 2025. Thus, for tax purposes, it's always better for landlords' rental activity to be a business, not an investment.
Rental Property as Business
Owning rental property qualifies as a business if you do it to earn a profit and work at it regularly and continuously. (Alvary v. United States, 302 F.2d 790 (2d Cir. 1962).) Applying this rather vague test is a highly factual determination. The IRS says that relevant factors that can be considered include, but are not limited to:
- the type of rented property (commercial versus residential property)
- the number of properties rented
- the owner's or the owner's agents day-to-day involvement
- the types and significance of any ancillary services provided under the lease
- the terms of the lease (for example, a short-term versus long-term lease), and
- whether the landlord has filed all required information returns. (Preamble to IRS Reg. 1.199A-1.)
Both the courts and the IRS have consistently found that landlords don't need to own very much property or do very much work to qualify as a business under this test.
Example: Edwin Curphey, a dermatologist, owned six rental properties in Hawaii. He converted a bedroom in his home into an office for his real estate activities. Curphey personally managed his rentals, which included seeking new tenants, supplying furnishings, and cleaning and otherwise preparing the units for new tenants. The court held that these activities were sufficiently regular and continuous to place him in the business of real estate rental. (Curphey v. Comm'r., 73 T.C. 766 (1980).)
You don't even have to do all the work yourself: You can hire a manager or others to help you and still qualify as a business.
Example: Gilford, her two sisters, and other relatives jointly owned eight apartment buildings in Manhattan. They hired a real estate agent to manage the properties and pay each family member their share of the net income. Gilford was found to be in business even though she spent little or no time managing the buildings. The court reasoned that the ownership and management of the buildings was a business because it required considerable time and effort by the real estate agent over several years. Because the agent acted for Gilford and was ultimately under her control, Gilford was in business through her agent. (Gilford v. Comm'r., 201 F.2d 735 (2d Cir. 1953).)
There is no specific number of rental properties or rental units you must own for your rental activity to qualify as a business. In one case, a married couple was found to be engaged in business even though all they owned was a 25% time-share interest in two condominium units. And, the actual work of renting out the units and keeping them in repair was performed by a management company that acted as their agent. (Murtaugh v. Comm'r., T.C. Memo 1997-319.)
Indeed, the tax court ruled back in 1946 that rental of one single-family residential unit constituted a business. This was so even though the only work the owner seemed to have done was listing the property for rent or sale with agents. (Hazard v. Comm'r, 7 T.C. 372.) The IRS agreed to follow this case (GCM 38779 (7/27//81) and the tax court continues to follow it throughout the country except the northeast. However, the IRS and courts have also said that renting of a single unit (or more) doesn't always constitute a business—it all depends on the facts and circ*mstances, including the number of properties rented, the day-to-day involvement of the owner or its agent, and the type of rental—for example, a short-term versus long-term lease.
Rental Property as Investment
Rental ownership is an investment, not a business, if you do it to earn a profit, but don't work at it regularly and continuously—either by yourself or with the help of a manager, agent, or others.
Example: Edgar Grier inherited a house from his mother that she had rented out for many years to the same tenant. This same tenant continued to occupy the property until Grier sold it 14 years later. Over the years, Grier managed the property himself or with the help of an agent. Little management work was required, but Grier did take care of such details as replacing the furnace. The IRS and court found that the house was an investment, not a business for Grier. The court noted that this was the only rental property Grier had ever owned and concluded that his landlord activities were too minimal to rise to the level of a business. (Grier v. United States, 120 F.Supp. 395 (D.Conn. 1954).)
Other cases where landlords have been found to be investors are those involving triple net leases of commercial properties where the tenant is required to manage the property and pay all taxes, insurance, and other expenses. The landlord does nothing but deposit the rent checks. Triple net leases are not usually used for residential rental properties. However, if you have an arrangement with a tenant that requires the tenant, not you, to take care of the property the IRS could conclude you're not in business. Courts have also held that landlords were not in business where they rented out their property only to their children or friends. Also, if your rental property is vacant all or most of the time, the IRS could decide that you are an investor, because you wouldn't need to spend much time dealing with the property.
Finally, people who purchase interests in business entities that own real estate, but aren't actively involved in management of the entities, are also investors for tax purposes. These include the limited partners in limited partnerships that own real estate, and people who own shares in corporations and REITs (real estate investment trusts).
Landlord Business Safe Harbor for Pass-Through Deduction
For purposes of the pass-through tax deduction only, the IRS has created a special safe harbor rule. Landlords who satisfy the rule's requirements are automatically deemed to be in business for purpose of the pass-through deduction, but for no other purpose. To qualify to use the safe harbor a landlord must:
- perform a total of 250 hours of real estate rental services each year (including work performed by employees and agents)
- keep records documenting the real estate services performed, and
- keep separate books and records showing income and expenses for each rental real estate enterprise. (IRS Notice 2019-7.)
Use of this safe harbor rule is purely optional. You don't need it if your rental activity qualifies as a business under the regular rules covered above. Also, the safe harbor can't be used by landlords who use the property involved as a residence more than 14 days during the year, which eliminates most short-term rental hosts.
More Information on Tax Issues for Landlords
See the Tax Deductions for Landlords section of the Nolo site for a wide variety of tax-related articles. Also, for a comprehensive treatment of the subject, see the Nolo book Every Landlord's Tax Deduction Guide, by Stephen Fishman.
