The Two Key Factors the IRS Uses for Landlord Tax Classification

The Two Key Factors the IRS Uses for Landlord Tax Classification

By utilizing tax deductions, you can save yourself a lot of money as a landlord.

There are three landlord classifications for tax purposes, and depending on your classification, you’ll have access to all, some, or none of the landlord tax deductions.

In this article, we will cover the two key factors the IRS uses to determine your tax classification and what these classifications mean.

The Factors

Motive and behavior are the two factors the IRS uses to decide how to classify landlords. Basically, if the IRS can determine that your primary motive with your rental activities is profit, then you qualify as a business owner. If not, then you’ll be classified as a not-for-profit owner or an investor depending on the situation.

One method the IRS uses to gauge whether you have a profit motive is the Three of Five Test. If you profited from your rental activities in three out of five successive years, the IRS assumes your motive is profit.

If you don’t meet the motive criteria for the business owner classification, you may still meet the behavior criteria. If you behave as though you intend to make a profit with your rental activities, then the IRS will classify you as a business owner.

For example, if you regularly and continuously manage your tenants and rental properties or hire someone to do so, this tells the IRS that you have a profit motive. Other behavior patterns that suggest your motive is to run a profitable business include keeping thorough records of payments, logging your time spent working, taking classes on rental income taxes or real estate, creating a business growth plan, and setting up a business checking account.

The Classifications

Based on your motive and behavior, the IRS places you into one of three classifications.

First up is the business owner classification. Being a business owner gives you the most beneficial tax deduction opportunities, and as a landlord, you should try your best to be classified in this category.

While we’ve already covered that a business owner’s goal must be to make a profit, business owners must also be involved in the day-to-day management of their rental properties. This doesn’t mean that you have to complete every property management task yourself. As a matter of fact, you can hire somebody to take care of all the essential tasks, such as listing your property, conducting tenant screening, collecting rent, managing maintenance requests, etc., and still be considered a business owner because you’re profiting off the work of someone you hired.

If you invest in a property hoping its value will increase over time without actively listing the property, seeking tenants, or managing the rental, then you’d be classified as an investor. 

For example, if you own properties, but the tenants manage the whole property (maintenance, taxes, insurance, etc.), then you’re an investor since you aren’t performing the regular and continuous management tasks.

The last IRS classification is the not-for-profit owner. As opposed to a business owner, a not-for-profit owner’s primary motive with their rental activities is something other than profit. 

If you rent your units at exceptionally cheap rates for charity or you use your properties for recreation, the IRS will assume you don’t have a profit motive. Another example of a not-for-profit owner is someone who owns a property they live in for half the year and allows family members to use it when they aren’t there.

The Deductions

So, what tax deductions for rental property does each classification qualify for? If you’re a not-for-profit owner, none of your rental expenses are deductible, even if you spend tons of money on repairs, insurance, or renovations. Investors can deduct some expenses, such as interest, repair costs, depreciation, and select operating expenses.

Business owners have the most to gain. Deducting real estate losses, start-up expenses, pass-through income, Section 179 expensing, and home office expenses are all possible if you’re classified as a business owner, on top of the deductions investors qualify for.


By looking at your motive and behavior, the IRS will determine which tax classification you belong to. Knowing the deduction benefits that business owners have, you should do your best to ensure that you meet the qualifications of this classification.

Leave a Reply

Your email address will not be published. Required fields are marked *