Is Your Rental Activity a Business or an Investment?
It's to landlords' advantage tax-wise to categorize your 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). 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, systematically, and continuously. (Alvary v. United States, 302 F.2d 790 (2d Cir. 1962).)
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 systematic and continuous to place him in the business of real estate rental. (Curphey v. Comm’r., 73 T.C. 766 (1980).)
However, you don’t have to do all the work yourself: You can hire a manager 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, several courts have stated that a landlord who owns a single rental property can be engaged in business. (Balsamo v. Comm’r., T.C. Memo 1987-477.)
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, systematically, and continuously—either by yourself or with the help of a manager, agent, or others.
Example: Byron Anderson rented a farm to a tenant farmer. Both the IRS and tax court found that he was an investor, not a business owner, because all he did was pay bills relating to the farm, deposit rent checks, keep records and files for the farm, and talk occasionally with his tenant on the telephone about operating the farm. They found these activities were not sufficiently continuous, systematic, or regular to be a business. (Anderson v. Comm’r., T.C. Memo 1982-576.)
Although renting even a single unit can be a business, in some cases, you could have trouble showing that your management activities (or those of an agent) are sufficiently continuous, systematic, and regular if you own only one or a few units. Ironically, this is more likely where you have good stable tenants who cause few problems and make little demand on your time.
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).)
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).
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.