Choosing rental property as investment or business

[Rdrunner510]

For at least the past ten years I have reported income and losses on the schedule E.  To date I've considered these seven single family homes investments, but they also qualify as a business, given the number of properties and level of participation, at lease based on my readins and examples).  (ADJ INC:  > $100,000 and

< $150, 000)  (2020 losses > $25,000)  From a loss deductible point of view (i.e. loss limitations) is it better to identify as a business or continue as a investment. Also, if I change to a business, does that mean I now have to complete the small business schedule.   My husband is considered a(no real estate professional and we actively and materially participate.  Our objective is to make a profit that adds to our income as retirees.

Thank you in advance.

CN

[Mike9241]

unless you can be classified as a real estate professional you are subject to the Passive Activity Loss Limit rules as to the real estate activities.  you may be a real estate professional. here are the rules. In Turbotax there is a question about being a REP

The IRS Publication 925 establishes the criteria necessary to qualify as a real estate professional for tax purposes. There are a few different ways to look at these rules, but generally speaking investors are required to spend a certain amount of time per year working in real estate. The real estate professional rules are as follows:

• More Than 50% Rule

• 750 Hour Requirement

• Single Taxpayer Requirement

• Material Participation

More Than 50% Rule

The first qualification set forth by the IRS states that more than half of the services performed within the tax year were in “real estate property trades or businesses.” This is commonly referred to as the more than 50 rule, meaning more than 50 percent of your working hours must be in real estate. The more than 50% rule generally eliminates anyone with a full-time job outside of real estate from being classified as a real estate professional. For example, if you work 40 hours a week at Google and spend about 5 to 10 hours per week managing a rental property — you will not qualify as a real estate professional when tax season comes around.

750 Hour Requirement

The second qualification for real estate professionals requires them to spend more than 750 hours in a year performing services related to real estate trades or businesses. To put that in perspective, a typically 9 to 5 employee works between 1600 and 1900 hours per year. The 750 hour requirement is calculated annually (from January to December) and there is no limit on when the hours are worked — so long as they fall within the tax year. The activities that count towards this professional requirement include:

• Rental unit management

• New Construction

• Property and business operations

• Time spent as a real estate agent or broker

• Property development or redevelopment

• Property acquisition

Real estate professionals are also generally told to consider their property interests as one business activity rather than separate businesses. That way, property management and operations on each home count towards the 750-hour requirement (versus each property having its own 750-hour requirement). Further, keep in mind that real estate professionals must document and prove these hours to the IRS.

Single Taxpayer Requirement

The above qualifications must be met by each person hoping to receive the real estate professional tax designation. In other words, you cannot combine hours with your business partner, and both receive the real estate professional tax benefits. Each taxpayer must prove the 50 percent rule and 750-hour requirement annually to be considered. However, there is an exception for married couples filing jointly. If you or your spouse meet the above requirements, the benefits of being a real estate professional would apply to your combined income — even if one spouse earned their primary income outside of real estate.

Material Participation

The IRS uses a system called the material participation test to determine if your working hours can count towards your designation as a real estate professional. These tests are a way for investors to prove that they materially participate in real estate business activities — rather than acting as passive owners. Generally speaking, you must meet at least one out of seven material participation criteria. One of the most common examples is to participate in the activity for at least 500 hours. As you might guess, this is frequently used because professionals must already prove that they work 750 hours in real estate.

in effect a real estate professional is in the business of real estate and the activity would then qualify as for the 199A deduction. (since only 250 hours are require - a non pro could also qualify for the 199A deduction)

WASHINGTON — The Internal Revenue Service today issued Revenue Procedure 2019-38 PDF that has a safe harbor allowing certain interests in rental real estate, including interests in mixed-use property, to be treated as a trade or business for purposes of the qualified business income deduction under section 199A of the Internal Revenue Code (section 199A deduction).

If all the safe harbor requirements are met, an interest in rental real estate will be treated as a single trade or business for purposes of the section 199A deduction. If an interest in real estate fails to satisfy all the requirements of the safe harbor, it may still be treated as a trade or business for purposes of the section 199A deduction if it otherwise meets the definition of a trade or business in the section 199A regulations.

This safe harbor is available for taxpayers who seek to claim the section 199A deduction with respect to a "rental real estate enterprise." Solely for purposes of this safe harbor, a rental real estate enterprise is defined as an interest in real property held to generate rental or lease income. It may consist of an interest in a single property or interests in multiple properties. The taxpayer or a relevant passthrough entity (RPE) relying on this revenue procedure must hold each interest directly or through an entity disregarded as an entity separate from its owner, such as a limited liability company with a single member.

The following requirements must be met by taxpayers or RPEs to qualify for this safe harbor:

• Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise.
• For rental real estate enterprises that have been in existence less than four years, 250 or more hours of rental services are performed per year. For other rental real estate enterprises, 250 or more hours of rental services are performed in at least three of the past five years.
• The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, regarding the following: hours of all services performed; description of all services performed; dates on which such services were performed; and who performed the services.
• The taxpayer or RPE attaches a statement to the return filed for the tax year(s) the safe harbor is relied upon.

For more information about this and other TCJA provisions, visit IRS.gov/taxreform.

[Carl]

As you can see from @Mike9241 's detailed response, qualifying as an RE professional is not simple for those who own 1-3 rental properties while working a W-2 job. If you've been on SCH E for the last 10 years, there's really no benefit I can see to changing anything.

As it stands, if you can meet the 250 hour rule then you might qualify for the QBI deduction. If you don't qualify for the QBI deduction on SCH E now, then you won't qualify by changing your rentals to a SCH C business either.

Some other stuff that may or may not apply to your specific situation.

Rental property in general produces passive income. That's why it's reported on SCH E and is not subject to the additional 15.3% Self-Employment tax.. The SCH C is used for "earned" income and that income "is" subject to the additional 15.3% self-employment tax.

I've seen instances where people put their rental property in an LLC only to find out they are "still" required to report it on SCH E. Thus, they don't have a single penny of "earned" income to report on SCH C. It really throws them for a loop when they discover this the hard way.

Now I'm not saying you can't report on SCH C (if you qualify). What I"m saying is that you need to determine if it's really worth it, and ask yourself "what do I gain by reporting as a SCH C business?"

If you qualify and decide to go the SCH C route, then understand it's not a simple matter of just moving all the data to SCH C. It's quite a bit more involved than that, and will require a lot of manual math on your part. One tiny mistake can cost you dearly years down the road too.

[Anonymous_]

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@Carl wrote:

Now I'm not saying you can't report on SCH C (if you qualify).

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The only taxpayers who "qualify" to report income from the rental of residential real estate on Schedule C (or otherwise as an active trade or business) are those who provide "services" to their tenants and real estate dealers. 

All others report on Schedule E regardless of their level of involvement in the rental activity.

[Carl]

are those who provide "services" to their tenants

TO be a bit more specific, isn't that "services to their tenants on a recurring basis that are directly beneficial to the tenant."?

I clarify, because for many, including lawn service or A/C maintenance in the rent doesn't count since that's something that would usually be done anyway, even if the property was not occupied. It's more like laundry service, meals, and that sorta stuff that is beneficial to the tenant more directly.

[Anonymous_ · Accepted solution]

The types of "Services" considered "services" that would be required to be reported on Schedule C (or otherwise, considered an active trade or business) has never actually been definitively listed with the exception of "maid service".

Otherwise, "services" do not include the furnishing of heat and light, cleaning of public areas, trash collection, or similar services.

[DiddlyD]

This year 2022 has a new caveat.   It has come to my attention the necessity for determining whether a landlord of rental property is a "Merchant" as some online payment processing companies are labeling us with because we are using the same platform as vendors do which is described as in the business of goods and services and will issue 1099-K if over 600.00 was transmitted to a person.  This issue is you can't report a1099-K on schedule E for one and the 1099-K can contain monies for non income purposes too like Refundable Deposits in Trust that IRS says not to include in income unless you have made a material deduction for which you have incurred an expense.  1099-K is associated with being in "Business" and reporting on schedule C.  Another thing to consider along with the rest in reporting passive income vs earned income.

Non Merchant is:

1)  Dealing in Real Property (apposed to movable property/goods)

2) Does not supply "Services" as in Meal, Shuttle, Maid, laundry services;  Including utilities is not a service

3) Is not considered "transient" accommodations called "Short Term" which is in the same business class as hotels and BNB's (rents for 29 or less nights, vs month to month).

[DiddlyD]

Correct!  Much like a Hotel or BnB does!  Short term rentals (less than 30 days) too because they are considered transient.

[Anonymous_ · Accepted solution]

The figure reported on a 1099-K (1a) can represent a plethora of types of income, some of which are not even taxable.

For example, the payment could simply be a gift that was processed through the likes of an app such as Venmo or Zelle.

Moreover, merely because the payment is processed through VRBO or AirBnB does not necessarily indicate that the rental income is reportable on Schedule C. There are numerous rentals through both sites where "services" are not provided and/or the rental periods are for longer than a day or a week or even a month.

In addition, the figure reported on a 1099-K could be of the type that would be reported as miscellaneous income not subject to self-employment tax (such as hobby income) or the sale of personal-use items that would be reported on Form 8949 (as the sale of capital assets).

Finally, note that a figure reported on a 1099-K is the gross amount of the payment processed without reduction for refunds, exchanges, etc. Therefore, a taxpayer could receive, for example, a 1099-K that shows $1,000 despite the fact that the taxpayer refunded 100% of the $1,000.

This is going to be a colossal mess for a lot of taxpayers and I would not be surprised in the least if adjustments in the law and/or regulations are made in the future.

[DiddlyD]

I did not say advertising on VRBO/Airbnb online market place sites who processes electronic payments on your behalf automatically makes you a business.  All I said is, IF you are in the classification of a "Short Term" rental, which is renting for less than 30 day stays (nightly/weekly), you will be considered in the category the same as Hotels/Motels and BNB's (bed and breakfast) due to it's transient nature and are also required to charge the same hotel tax rates too. Those are defined as being in the Hospitality Business.   States changed zoning laws to accommodate the booming short term rentals they facilitate in exchange for the online vacation rental market place collecting and remitting sales tax to them, now the feds want to make sure they get their taxes too.  There are of course long term "vacation" rentals advertising on those sites too that rent strictly by the month or more and do not fall in that class.  I haven't used those platforms since they started charging booking fees and wanted to take control of too much plus I'm not a short term rental either and they made a mess of the monthly quotes they gave people because they use a average nightly rate to figure it when a month could be 28, 30 or 31 days and they would have to put in an end date of another night into the next month.  I only use an online rent processing app for my rentals to submit their rent, but they all will issue 1099-K if they transferred over 600.00 to you effective tax year 2022.

I agree with all you points except I don't think I suggested if you advertised on the online Vacation Market places you must file schedule C.  But 1099-K can only be reported on Schedule C not on E.  I have contacted both Rent payment app and the bank Vendor services that I am not a Merchant, but they insist they have to send me a 1099-K.  I finally came to the conclusion because I have refundable security deposits and refundable cleaning deposits remitted online and that because I report on schedule E, I will just file the 1099-K with my copy of tax records and forget about it.  The IRS has a mess they created to deal with.  I guess if the IRS gets the 1099-K too, they can cross check to see if large electronic transactions are not being reported, they will just have to audit me then because I have done the research and feel I am properly reporting my rental income on Schedule E and will continue to do so without using anything in my reporting from the 1099-K as it was suggested to take an expense deduction for Security Deposits which is even worse and most likely be flagged.  I used Zelle at one time before 2022 where a tenant could just transfer their rent to my account but it allows a tenant to make a partial payment making it difficult to evict and I don't use it anymore. I'm not sure how PayPal and Zelle etc will handle this new IRS requirement, well see I guess.

[Anonymous_]

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@DiddlyD wrote:

All I said is, IF you are in the classification of a "Short Term" rental, which is renting for less than 30 day stays (nightly/weekly), you will be considered in the category the same as Hotels/Motels and BNB's (bed and breakfast) due to it's transient nature.....

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Sorry, but the above-quoted statement is simply not accurate with respect to federal income tax laws and regulations. 

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@DiddlyD wrote:

.....1099-K can only be reported on Schedule C not on E.

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Again, not accurate and I highly the source of your information and even Intuit (TurboTax) disagrees with you.

[DiddlyD]

Well actually you proved me right, because Schedule E is to report passive income not earned income as in a "business" look at the tab you are under that is not Schedule E!  

Everywhere online regarding tax filing involving the 1099-K gives instructions: To report your 1099-K income on this form, simply enter your gross 1099-Kincome on line 1 of Schedule C.

And as for the definition of "Services" it is clear: Services are the non-physical, intangible parts of our economy, as opposed to goods, which we can touch or handle. 

[Anonymous_]

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@DiddlyD wrote:

Well actually you proved me right, because Schedule E is to report passive income not earned income as in a "business" look at the tab you are under that is not Schedule E!  

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Again, the above-quoted statement is inaccurate and you are mistaken. Income/loss reported on Schedule E income/loss can be passive or nonpassive and the income entered in TurboTax as 1099-K income is reported on Schedule E by the program. 

In fact, you clearly do not understand the difference between earned income and passive income. The latter can still be considered a type of "business" income for purposes of federal income tax law and regulations (e.g., the QBI deduction). 

[DiddlyD]

Well Turbo tax has it wrong then.  

1) According to the IRS: "Generally, Schedule C is used when you provide substantial services [i.e. hotel like services] in conjunction with the property or the rental is part of a trade or business as a real estate dealer."

2) Generally, unless you meet the qualifications to be considered a real estate professional, your rentalincome is passive and should be reported onto a Schedule E. If you meet the qualifications to be considered a real estate professional, your rental income is not considered to be passive, and can be reported onto a Schedule C.

[Anonymous_]

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@DiddlyD wrote:

If you meet the qualifications to be considered a real estate professional, your rental income is not considered to be passive, and can be reported onto a Schedule C.

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Again, the above-quoted statement is simply false. Real estate professionals report on Schedule E unless they are either considered to be real estate dealers or provide substantial services to their renters.

You clearly are laboring under a misconception as to what constitutes passive income and earned income. All income that is not passive is not necessarily "earned income" that is reported on Schedule C. Actually, the opposite of passive income is nonpassive income.