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December 20, 2023 | read

Landlords: Are You an Investor or Business Owner?

Brandon Hall

Business owners make a profit by actively managing their business. Passive investors make money when their assets increase in value as they don’t actively manage their holdings.

As a landlord, you want your rentals to qualify as a business, especially with the 2018 IRC Sec. 199A pass-through deduction. While qualifying as a passive investor still affords you similar tax benefits, you will also lose valuable tax deductions!

Landlords owning rental property will qualify as a business owner if they do it to earn a profit and work at it regularly, systematically, and continuously. (Alvary v. United States, 302 F.2d 790 (2d Cir. 1962).)

Landlords do not have to do all the work themselves as they can hire and manage property managers and contractors but still be engaged in rentals to earn a profit (Gilford v. Comm’r., 201 F.2d 735 (2d Cir. 1953)).

Additionally, if a landlord’s rental unit is vacant it doesn’t necessarily preclude them from qualify as a business owner as long as the rental unit was marketed for rent (Jephson v. Comm’r, 37 B.T.A. 1117 (1938)).

In Murtaugh v. Comm’r., T.C. Memo 1997-319 it was found that the taxpayers only had a 25% stake in a timeshare unit and were still able to qualify as business owners. Additionally, in Balsamo v. Comm’r., T.C. Memo 1987-477 it was established as a general rule that owning only one rental property and qualify as a business operation. So you don’t need an expansive portfolio in order to qualify as a business.

How to Prove Your Landlording Business is “For Profit”

Earning a profit in your rental activity proves you are a business owner and not just an investor. Here’s how you prove your rentals are “for profit.”

3 of 5 year test

If your rental activities earn a profit in three of the past five years, the IRS must preclude that you are operating a business. If you cannot meet this test, you run the danger of being classified as an investor, but that’s also why we have a “behavior” test.

Behavior test

You can operate rentals at a loss every single year and still qualify as a business owner as long as you meet the behavior test. The following factors are what and the auditor will use to judge if your behavior is profit motivated, the first three being the most important:

  • How the activity is carried on – do you act as a business would?
  • The landlord’s expertise – what is your knowledge and skill level of real estate?
  • The time and effort spent – how much time do you spend on your rental activities compared to your other activities?
  • Your track record
  • Your history of income and losses
  • Your profits
  • Appreciation of the real estate
  • Your net worth
  • What you do for fun and recreation

To pass the behavior test, you must maintain good records. Keep your accounting clean and a log of the time you spend on all of your activities. Establish your expertise through guest blogs and podcasts and document that you feel your real estate will appreciate in value.

When Rentals Do Not Qualify as a Business

If your activities qualify as an investor and not as a business owner, you may lose the ability to claim the tax deductions listed below.

Our clients who have crossed the line into investor activities typically do so when they are:

  • Investing in mortgage notes passively
  • Investing as an LP in real estate syndications
  • Have a small portfolio of rental units that is leased out and doesn’t require much time to manage
  • Owns triple net lease properties
  • Buys and holds land for future sale

The tax deductions you will lose if your activities qualify as an investor rather than business owner are as follows:

  • Passive losses from real estate – investors can only deduct $3,000 per year in capital losses
  • Home office deduction – investors cannot deduct their home office because they are not engaged in a trade or business
  • Start-up costs
  • Section 179 expensing
  • Conventions and seminars