Let's get the basics out of the way. The first thing to establish is your perspective about your rental property. How should you report your rental real estate on your tax return? Is it a business, or merely an investment? This distinction can make a big difference, in the form of the famous Sec. 199A deduction (Qualified Business Income aka QBI).
Generally, I would recommend taking the perspective that your rental property investment is a business. Your goal is to maximize your profits, minimize your expenses (especially taxes), and increase your maximum cash flow to your pockets from your property. Any business owner would say the same.
Understanding Rental Real Estate Taxation
Hold on a second. Not every real estate investment will qualify as a business venture. We consider three different categories of real estate activity for tax purposes.
Hybrid, A 'Passive' Business
According to the IRS, for purposes of the 199A deduction, your activity qualifies as a trade or business under the ambiguous requirement of being conducted "on a regular, continuous, and substantial basis" to earn a profit.
What does this look like for a real estate investor? Well the IRS specifies in Revenue Procedure 2019-38, which says that a rental real estate enterprise (RREE) is considered a trade or business if you:
Maintain separate books and records for the property
Perform at least 250 hours of rental service per year (we won't go into what qualifies as a rental service in this article, but Revenue Procedure 2019-38 has all the juicy details. Hint: you can combine activities at multiple rental properties to meet this requirement).
Keep logs, time reports, or other records detailing services performed
Files a statement with their tax return
Passive Real Estate
There are also investors purchasing a sliver of ownership in real estate syndicates or other entities. This includes REITS (Real Estate Investment Trusts) offered through your brokerage account, and even private groups that offer partial ownership of real estate properties. You typically have no control and do not actively participate in decisions, and sometimes you can't even divest without severe penalties. This is considered passive income.
From a tax planning perspective, we consider these types of investments for their use in offsetting other sources of passive income. They can also become powerful when coupled with other real estate investments.
Full Blown Business
In this category, you live and breathe real estate. Brokerage commissions, management fees, and fix-and-flip activities are your bread and butter. Doesn't get more simple than that.
A full-blown business is Real Estate Tax Nirvana. A Real Estate Professional is entitled to deduct losses from their rental properties against wages or other income and avoid net investment income tax on income from their rental properties. To qualify as a Real Estate Professional, you must spend at least 750 hours per year -- and more than half of your total working hours -- on real estate businesses. This qualification is worth an entirely separate article.
Apply an Entrepreneurial Mindset
The key takeaway is that you want to approach your rental property and real estate investments with the mindset of an entrepreneur.
Rental real estate activities typically default to passive status but can be recharacterized in certain circumstances. If you meet the requirements to be a rental real estate professional, your rental income is treated as nonpassive and might unlock major tax benefits.
To qualify for the Section 199A qualified business income deduction, you must establish that you are engaged in a trade or business. The rental of real estate will be considered a trade or business if you engage in regular and continuous activity with respect to the property rented, even if only one property is rented.
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