Rental property taxes are one of the most complex aspects of owning a rental business.
When you file your taxes, simply owning a property does not guarantee you the best landlord tax deductions. Before you can claim any deductions, you must identify your landlord tax classification.
This is necessary because the IRS treats you differently depending on the nature of your rental activities. If you meet the requirements to be classified as a business owner, you gain access to the best tax deductions and deals.
If not, you might be classified as a real estate investor or not-for-profit owner. These classifications can claim far fewer deductions.
Here are some tips for proving your rental business owner classification to the IRS so you can achieve the highest tax refund.
1. Make a Profit
The quickest way to prove your rental business status to the IRS is to make a profit.
Since businesses are fundamentally for-profit, showing that you are profiting from your rental activities is a sure way to prove that you are a business.
The tax code provides a convenient test for profit. According to the Three of Five test, if you made a profit from your rental activities in three out of the last five consecutive tax years, you automatically qualify as a business. Keep in mind that any profit will do, no matter how small.
2. Prove a Profit Motive
What happens if you didn’t make a profit? If this is your case, don’t panic. You can still be classified as a business even if you don’t make a profit. You just need to prove that you want to.
Proving a profit motive can be as simple as diligent bookkeeping and organization. Here are some tips and strategies for demonstrating a profit motive:
- Keep excellent records of your income and expenses. Prove that you care about your finances and are tracking their growth. Try using the expense tracking feature on your property management software.
- Log your work hours. Show that you’re working regularly and consistently to achieve your profit goals.
- Open a separate checking account. Separate your rental and personal finances.
- Outline a growth plan. Show that you expect to make a profit soon.
- Show your expertise. If you aren’t making a profit, take classes or attend seminars to show you’re learning how to better manage your business.
3. Behave Like a Business
Your behavior is also an important factor in your tax classification.
To be classified as a business, you must actively manage your rental business on a continuous and regular basis or be actively seeking tenants.
The lower your involvement in your rental activities, the higher your risk of being classified as a passive investor rather than a business owner.
If you hire a property manager to look after your properties, you can still pass the behavior test. As long as you or someone you hired directly works to manage the day-to-day tasks and decision-making of your business, your behavior matches that of a business.
4. Don’t Let Tenants Manage the Property
If you have an agreement with your tenants that enables them to manage all or part of the property, this may interfere with your business classification.
This is because, without your direct management, you may fail the behavior test. You should be the one actively managing maintenance, tenant screening, property taxes, titles, etc.
5. Don’t Let Units Lie Vacant
If you own property that has been vacant for a long time, the IRS may see this as a red flag. You may be classified as a not-for-profit owner instead of a business owner because you aren’t seriously seeking tenants to pay rent and help you profit.
Furthermore, if it’s clear that you only rent your units out occasionally to friends and family members, you might also lose your business status. Using your property exclusively as a family vacation home is fine, but you won’t be able to qualify as a rental business owner.
6. Rent at Market Rates
You must rent at or above market rates to qualify as a business. If you consistently rent at below-market rates, this may be interpreted as a favor to people you know. You aren’t running a business because you aren’t trying to compete in the rental marketplace.
7. Save Listings & Advertisements
Finally, always save copies of your listings and advertisements. These could be on listing sites like Zillow or in print publications. If audited, you can use the dates on these listings to prove that you are actively seeking tenants for your properties and aren’t allowing them to lie vacant.
Claiming Rental Business Deductions
If you follow the above advice, you have a high probability of achieving the business tax classification. By claiming rental business deductions, you’ll have access to numerous tax benefits that will help your rental business continue to grow.