Landlords' Business Tax Benefits & Legal Obligations
People who receive income from renting property may wonder whether this activity qualifies as a business. One of the main benefits of qualifying as a business for tax purposes is that you can potentially claim the pass-through deduction under the Tax Cuts and Jobs Act. This allows a landlord to deduct up to 20 percent of their net rental income.
The definition of a business for the purposes of tax rules is an activity in which the taxpayer engages regularly and continuously with the primary purpose of earning a profit. Engaging regularly and continuously in the activity does not mean that it is your only activity, or that you cannot hire people to help you with it. If you lease many rental units, your activity likely qualifies as a business. If you lease only one unit or a handful of units, you may have more trouble qualifying as a business. However, you still may be able to claim the pass-through deduction if you qualify for the safe harbor discussed below.
Claiming the Pass-Through Deduction
There are three main requirements for claiming the deduction. First, a landlord must own the property that they are leasing personally or through a pass-through business. (A pass-through business might be a partnership or a limited liability company, among other examples.) Also, the landlord must have received a net rental profit during that year. Finally, they must receive more total income, counting all of their income sources, than the amount covered by their deductions.
Safe Harbor for Small Landlords
If you are uncertain about whether you qualify as a business, you may be able to claim the pass-through deduction if you meet two additional requirements. First, you must perform 250 hours of real estate rental services each year. You must keep records of the services that you performed. In addition, you must keep separate books and records to show your income and expenses for each of your rental activities. This is a prudent step for landlords to take, regardless of whether they are claiming the deduction. Landlords who rent more than one residential property can treat them as a single property for the purpose of qualifying for the safe harbor. Commercial rental properties do not help a landlord qualify.
Certain exceptions apply to the safe harbor rule. If the lease requires the tenant to pay for maintaining the property and cover insurance costs, you cannot use the safe harbor. You cannot use the safe harbor if you lived in the rental property for more than 14 days in the year for which you are claiming the deduction. The safe harbor also does not apply if you lived in the rental property for a number of days that is more than 10 percent of the number of days during the year for which you rented the property.
Proving Eligibility for the Safe Harbor
Only certain types of activities count toward the 250 hours of real estate rental services. For example, you can count time spent in negotiating a lease, advertising to prospective tenants, collecting rent, maintaining the property, supervising your employees, or otherwise managing the property. On the other hand, you cannot count time spent in buying the rental property, adding long-term improvements to the property, or traveling to the property. Any activities related to managing finances or investments related to the property do not count.
You do not need to personally perform all of the qualifying services. You might hire employees or independent contractors to handle the tasks on your behalf, in which case they still would count. Before 2023, the 250-hour requirement applied on an annual basis. Starting in 2023, a landlord can meet the 250-hour requirement if they met this threshold in three of the previous five years, ending with the year for which they are claiming the deduction.
A landlord needs to keep records of the hours that they devoted to performing real estate services, the dates on which they performed these services, and the people who performed them. The records also should include a description of the services. If a landlord has hired other people to perform these services, they should tell those people to keep records of the time that they spent working for the landlord. Landlords do not need to submit the records to the IRS but simply make them available for inspection upon request.
Going Outside the Safe Harbor
You should be aware that you do not necessarily need to qualify for the safe harbor to qualify as a business. No absolute rules apply to rental activities that do not qualify for the safe harbor. Each situation is unique and evaluated on its own facts, especially the degree to which the landlord or people who work for them are involved in managing the property. You may want to consult a tax professional for advice on whether you still may be able to claim the pass-through deduction if you do not meet the safe harbor requirements.
Filing Form 1099-NEC as a Landlord
Many landlords have wondered whether they should file IRS Form 1099-NEC if they make payments to independent contractors who perform services related to their rental operation. Under the Tax Cuts and Jobs Act, filing this form is a smart strategy for a landlord. It can help them take advantage of business tax deductions by showing that their rental operation is a business rather than an investment activity. These deductions may include not only the pass-through deduction discussed above but also deductions for start-up expenses and a home office. Failing to file Form 1099 when appropriate likely will lead the IRS to conclude that the rental operation is not a business.
A landlord also may qualify for a deduction against their total income if they sell their rental property at a loss. They can get a small deduction if it qualifies as an investment activity, but there is no limit on the deduction if it qualifies as a business.
In general, a business owner must file Form 1099 if they pay an independent contractor at least $600 during a year for services related to their business activity. There is an exception for credit card and electronic payments, which do not need to be reported by a business owner.
