Are your Rental Properties a Business? If so, you Win!

COULD your rental property activity meet the definition of a trade or business activity?

If YES, your rentals produce the best tax benefits. In general, you report your rental properties on Schedule E of your tax return. When your activity rises to the level of a business, you continue to report the rentals on Schedule E, but with the business classification, you qualify for...

* tax-favored Section 1231 treatment * business use of an office in your home

* business (versus investment) treatment of meetings, seminars, and conventions

and...

* Section 179 treatment of your business-use assets. Rental as a Business:

In the tax court case involving Levy (trustee), the court ruled that... 1 The trustees of this estate, by renting the real estate, were engaged in a trade or business.

The court then went on to say this:

2 Courts have consistently held that the rental of real estate is a "trade or business" if the taxpayer-lessor engages in "regular and continuous activity" in relation to the property. It has been held that a taxpayer who rents only a single parcel of real estate is engaged in the "trade or business" of renting real estate if his activities are regular and continuous. The fact that the trustees employed agents to manage the real property does not make any difference.

In (tax court case) Elek:

3 The taxpayer purchased an apartment building in Hungary, appointed his father manager, left Hungary, came to the United States, and became a citizen. During this time, the Hungarian government by decree nationalized his property because it was owned by a capitalist. The court granted Mr. Elek a business loss on this rental because it considered his rental apartment activity a trade or business for which nationalization caused his net operating loss.

In (tax court case) Cottle:

4 The court ruled that Mr. Cottle bought three fourplexes in what was for him a new trade or business of renting apartments.

In Jephson: 5 The court ruled that George Jephson had a business when he bought a house to rent, listed it for rent, and showed it to prospective tenants but never rented it.

Tax-Favored Section 1231 Treatment

In a private letter ruling, the IRS sums up its view of property that qualifies for tax-favored Section 1231 treatment with these comments:

6 The mere rental of real property does not constitute a trade or business under Section 1231 of the Code. In order to constitute property used in a trade or business under Section 1231, the income or gain must be derived from properties used in the active conduct of a trade or business as opposed to property which is reasonably expected to generate passive income such as portfolio investments. The two big tax benefits of Section 1231 treatment are: Tax law treats net Section 1231 losses as ordinary losses that you use to offset ordinary income.

Tax law treats net Section 1231 gains as long-term capital gains. This gives you the best of both worlds: ordinary losses and long-term capital gains. TIP: Beware. If you have a net Section 1231 gain within five years after you have a net Section 1231 ordinary loss, you must recapture the gain as ordinary income to the extent of the losses and pay taxes at the recapture rates. TIP: Planning. Keep Section 1231 long-term capital gains and ordinary losses in your pockets. Avoid the five-year recapture problem. Home-Office Deduction You may claim a home-office deduction only for trade or business activities. Investment activities are not trade or business activities.

In Curphey, the Tax Court ruled that Dr. Curphey’s ownership and management from his home of three condo units, two townhouses, and one single-family home rose to the level of a trade or business for purposes of his claiming the home-office deduction. In this case, Dr. Curphey, a dermatologist, worked 40 hours a week at the hospital and also managed the six units, where he.. * sought new tenants

* supplied furnishings * cleaned, and otherwise prepared the units for new tenants. TIP: Planning note. Dr. Curphey reported his rental property deductions on Schedule E, not Schedule C. The fact that he is in the rental business does not alter his reporting of the rentals as rentals on Schedule E.

Investment Seminars, Meetings, and Conventions Tax law normally grants no deduction for travel or other costs of attending a convention, seminar, or similar meeting UNLESS the activity relates to a trade or business of the taxpayer. Thus, if your rental property is an investment, kiss goodbye those deductions for rental property conventions, seminars, and similar meetings. Tax law is clear: You may not deduct registration fees, travel and transportation costs, and meal and lodging expenses incurred in connection with attending an investment seminar or similar meeting relating to investments, financial planning, or other activities for the production or collection of income. TIP: Planning. Make sure your involvement in your rental property rises to the level of a trade or business if you plan to deduct your attendance at rental property investment seminars and meetings. HOW? One way is to track the time you spend managing your business in something as simple as a "diary" or detailed calendar. Section 179 Expensing With respect to rental properties and Section 179 expensing, you need to pay attention to the following three rules, which can impact your expensing: 1 You may not claim Section 179 expensing on most assets used to furnish lodging. 2 To qualify for Section 179 expensing, you must purchase and place the property in use in the active conduct of your business.

3 You may claim Section 179 expensing on qualified assets purchased and placed in service for use in transient lodging facilities (where the average stay of renters is less than 30 days). Lodging.

When you have residential rentals, your Section 179 possibilities run into the lodging problem. Here’s how one taxpayer got surprised and what that can mean for you. This case took place during those tax years when you could claim the investment tax credit on a new business car.

Dorothy LaPoint bought a new BMW and used it to travel to inspect and repair her residential rental properties. The court ruled that Ms. LaPoint used her car to furnish lodging and that use violated the no-tax-credit-for-lodging rule; therefore, Ms. LaPoint did not qualify for the investment tax credit.14

The old investment tax credit rule that prohibited lodging use is the same rule that prohibits Section 179 expensing for residential rentals. Example. You own a new BMW X5 on which you want to claim $25,000 of Section 179 expensing. If you use the X5 more than half the time for your lodging properties, you don’t qualify for Section 179 expensing. Planning. If you have a vehicle you deduct for both business and rental use, try to minimize residential rental property use. For example, you might make stops at the rentals on the way to and from the office, which could mean zero or very little rental mileage. Business of residential rentals. When you have residential rental activities that qualify as a business, you might have two types of furniture and equipment:

Qualifying Section 179 business furniture and equipment, such as the computers, desks, and chairs in the business office you use to run the lodging activities Nonqualifying Section 179 furniture and equipment used for or in connection with the furnishing of lodging, such as the beds and dishwashers in your apartment building Business properties.

If you own commercial buildings or shopping centers, you don’t run into the lodging problem. For example, say you spend $20,000 on a parking lot sweeper for use at your shopping center. This sweeper qualifies for Section 179 expensing.

If this sweeper were used at a residential apartment building, the sweeper would not qualify for Section 179 expensing. It would qualify for depreciation but not expensing.

Transient exception: Your rental property might qualify as a Section 179 tax-law-defined hotel under the transient exception (short term rental STR, such as AirBnB). If so, then your purchases of Section 179 equipment would qualify for expensing without facing the lodging problem. You have a hotel when your rental is used predominantly to furnish lodging to transients.

“Predominant” means more than one-half. “Transient” means the average rental period is less than 30 days.

Example. You rent your beach home for 27 weeks to 16 tenants. The average stay per tenant is 12 days (27 times 7 divided by 16). The used dishwasher and new living room furniture you purchased for the beach home this year qualify for Section 179 expensing.

Takeaways:

You can see that you want your rental activity to rise to the level of a business activity so that you can gain tax-favored Section 1231 treatment; business use of an office in your home; business (versus investment) treatment of meetings, seminars, and conventions; and Section 179 treatment of your business-use assets. The more rentals you can qualify this way the better.

TIP: Remember that you report the rentals on Schedule E whether or not they rise to the level of a business.

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