When it comes to the accounting and tax outcomes of real estate properties, you generally have passive income or active income. Depending on the specific activity you're involved in, you’ll want to hold it in either an LLC or an S Corp. Whether you are fixing and flipping or have another real estate business—like buy-and-hold investing or any of the other strategies—you're allowed to take tax deductions. This is not an all-inclusive list, but it illustrates that regardless of whether your activity is passive or active, these deductions still apply. However, whether you're buying and holding or flipping, you may need to handle these expenses differently.
In a buy-and-hold scenario, you have income when you receive rental payments. If you purchase something physical for more than $2,500, it should generally be treated as an asset. If it’s less than $2,500, you can expense it immediately. Most other expenses are expensed as they arise. The most common expenses you'll see for buy-and-hold properties are depreciation, interest, and property taxes. This type of investment is considered passive.
Now, imagine instead of buying and holding, you bought a property to fix and flip. In this case, you don’t have income until you sell the property, and it’s not considered rental income—it's classified as sales proceeds. When fixing and flipping, the IRS essentially treats you like a business selling inventory. Instead of selling a simple product, you’re selling a much larger, more complex “widget”—a home. Everything related to this process is considered inventory, meaning you don't get a tax deduction in the year you spend money unless you sell the property in that same year. Your taxable gain is calculated as your sale proceeds minus your cost of goods sold (COGS), which includes every dollar spent on the property—repairs, improvements, contract labor, interest expenses, and more.
Short-term rental properties can be classified under tax rules as either a business short-term or passive short-term, with or without material participation. This creates four potential classifications:
- Business short-term with material participation
- Business short-term without material participation
- Passive short-term with material participation
- Passive short-term without material participation
To determine the classification of your rental property, consider the following criteria:
- Average length of stay: This is calculated by dividing the total rental days by the number of unique renters. If the average stay is less than seven days, you may qualify for ordinary loss treatment if you materially participate. If it’s more than seven days, the activity is considered passive, and you can't take ordinary losses.
- Substantial services: Providing extra amenities can be beneficial for attracting renters, but if your services are too extensive, the IRS may classify your business as a hotel, resulting in active income subject to a 15.3% self-employment tax.
- Material participation: This allows you to treat losses as ordinary losses, which can offset your other income. To qualify, you must meet one of seven participation tests. The two most common are:
- Participating in the activity for more than 500 hours.
- Your participation being substantial compared to others involved.
Ultimately, the goal is to help you avoid unnecessary self-employment tax or having your losses limited on your tax return. Having your properties inside an LLC is crucial because it provides flexibility. For example, if you have a short-term rental and believe you’re not providing substantial services, but the IRS decides otherwise, you can elect to treat the entity as an S Corp to protect yourself from the self-employment tax scenario. If the property is not held in an LLC, you lose that flexibility.
If you're in the business of real estate, many of the expenses listed here may be tax-deductible, as long as they can be related to your business. If you have any questions or need support, don't hesitate to reach out to us—we're here to help. And just in case I mumbled through it earlier, let me reiterate: The IRS sucks.
