If you own rental real estate, its classification as a trade or business rather than an investment can have a big impact on your tax bill. The distinction is especially important because of the 20% Section 199A deduction for certain sole proprietors and pass-through entity owners.
The 199A deduction is available for qualified business income (QBI), which can come from an eligible trade or business, but not from an investment. So, assuming you otherwise meet the requirements, qualifying your rental real estate activities as a trade or business may yield substantial tax savings. Fortunately, an IRS Revenue Procedure establishes a safe harbor.
The 199A deduction is too complex to cover fully here. But, in general, it allows owners of sole proprietorships and pass-through entities — partnerships, S corporations and, generally limited liability companies (LLCs) — to deduct as much as 20% of their net business income, without the need to itemize.
Eligible owners are entitled to the full deduction so long as their taxable income doesn’t exceed an inflation-adjusted threshold (for tax year 2021, $164,900 for singles and heads of households; $329,800 for joint filers). Above the threshold, the deduction may be reduced or eliminated for businesses that perform certain services or lack sufficient W-2 wages or depreciable property.
Have you ever wondered why some properties don’t make the cut as investment properties? I’ve been in real estate for years, and this question comes up all the time. Whether you’re planning a 1031 exchange or just trying to understand tax implications, knowing what doesn’t qualify can save you major headaches (and money!).
Investment properties offer fantastic tax advantages, but the IRS has specific rules about what counts. Let’s dive into which properties don’t qualify as investment properties and why.
Primary Residences: The Big Non-Qualifier
Your home sweet home is probably the biggest property that doesn’t qualify as an investment property The IRS is pretty clear on this – a primary residence isn’t considered an investment property because you’re not holding it for business or investment purposes
Why doesn’t your home count? Simple – you live in it! The IRS views investment properties as assets held to generate income or appreciation, not to provide you shelter.
However, there are some exceptions worth knowing about:
- Section 121 Exclusion: If you’ve lived in your home for at least 2 of the last 5 years, you might qualify for tax exclusion on gains up to $250,000 (single filers) or $500,000 (joint filers).
- Multi-family Properties: If you live in one unit of a multi-family property and rent out the others, the rental portion might qualify as an investment property.
I remember when my client Jake tried to claim his house as an investment property just because he was about to move out and rent it. The IRS wasn’t having it – planning is essential, and you can’t suddenly decide your primary residence is an investment property just because it’s convenient.
Flipped Properties and Short-Term Developments
Another category that doesn’t make the investment property grade is property held as inventory This includes
- Fix and flip properties: If you buy homes, renovate them, and sell quickly for profit
- Short-term development land: Property you acquire to develop and sell rather than hold
These properties are considered inventory in your business, not investment assets. The IRS views them as part of your regular business operations rather than long-term investments.
I worked with a developer last year who was shocked to discover his six-month flip projects didn’t qualify for 1031 exchange treatment. The key distinction? Intent and holding period. Investment properties are typically held for rental income or long-term appreciation.
Foreign Properties (in Some Cases)
Geographic location matters too. While domestic-to-domestic and foreign-to-foreign exchanges are fine for 1031 purposes, domestic-to-foreign exchanges don’t qualify. This means:
- You can’t exchange a U.S. property for a property in another country and get 1031 treatment
- The location of your investment matters as much as the type
Business Ownership Interests
Here’s where things get interesting. Shares or ownership stakes in most business entities don’t qualify as investment property for 1031 exchanges:
- Partnerships
- LLCs
- Corporations
The only exception? Delaware Statutory Trusts (DSTs). These are the only form of indirect ownership that qualifies for 1031 exchange treatment.
Properties Without Proper Documentation
According to tax professionals, even a legitimate investment property might not qualify if you don’t have the proper documentation. For a rental property to qualify as a business (which can affect tax benefits like the Section 199A deduction), you need to:
- Maintain separate books and records for the property
- Perform at least 250 hours of rental services annually (or meet this requirement in 3 of the last 5 years for properties held 4+ years)
- Keep detailed logs of services performed
- File proper statements with tax returns
I’ve seen many landlords miss out on tax advantages simply because they didn’t keep good records. Don’t make that mistake!
Properties That Don’t Meet the “Trade or Business” Test
For some tax benefits like the 20% Section 199A deduction, your rental property needs to qualify as a “trade or business” rather than just an investment. This distinction can be tricky.
The IRS considers an activity a trade or business if it’s conducted “on a regular, continuous and substantial basis” with the aim of earning profit. If your rental activity is too passive or limited, it might not qualify.
To pass the “trade or business” test, the IRS has established a safe harbor for rental real estate enterprises (RREEs). You must:
- Keep separate books and records
- Perform 250+ hours of rental services yearly
- Maintain contemporaneous records
- File appropriate statements
The Real Estate Professional Distinction
Another interesting angle is the “real estate professional” status. Normally, rental real estate is considered a passive activity regardless of your involvement. But real estate professionals get special treatment.
To qualify as a real estate professional, you must:
- Spend at least 750 hours annually in real estate businesses
- Devote more than half your total working hours to real estate activities
- Materially participate in these activities
If you meet these criteria, you can treat your rental properties differently for tax purposes.
Why This All Matters: Tax Implications
Understanding what doesn’t qualify as investment property isn’t just academic – it affects your bottom line in several ways:
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Capital Gains Tax Deferral: 1031 exchanges let you defer taxes when selling investment property, but only if the property qualifies.
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Deductions: Investment properties allow for deductions that primary residences don’t.
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Section 199A Deduction: This potentially gives you a 20% deduction on qualified business income, but only if your rental activity qualifies as a business.
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Passive Activity Rules: These determine whether losses from rental activities can offset other income.
Common Misconceptions About Investment Properties
I’ve noticed some confusion among property owners about what qualifies as investment property:
Misconception #1: “I’m planning to sell my house for profit, so it’s an investment property.”
Reality: Intent to profit doesn’t automatically make your primary residence an investment property in the eyes of the IRS.
Misconception #2: “I bought a vacation home that I sometimes rent out, so it’s definitely an investment property.”
Reality: Mixed-use properties fall into a gray area. The proportion of personal vs. rental use matters significantly.
Misconception #3: “Any property I don’t live in must be an investment property.”
Reality: Properties held primarily for resale (like flips) are inventory, not investment properties.
How to Convert Non-Qualifying Property to Investment Property
If you have property that doesn’t currently qualify as investment property but you want it to, there are legitimate strategies:
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Convert your primary residence: Move out and rent it for a significant period before selling.
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Restructure your rental activities: For example, if you have residential and commercial properties that each fall short of the 250-hour service requirement, consider exchanging for properties of the same type to combine them into a qualifying enterprise.
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Improve documentation: Start maintaining proper records to satisfy IRS requirements.
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Extend holding periods: For properties that might be considered “flips,” consider holding them longer as rentals first.
Strategic Planning for Investment Properties
The best approach is always proactive planning. Here’s what I recommend:
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Consult with tax professionals early: Don’t wait until you’re ready to sell to find out if your property qualifies for preferential treatment.
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Document everything: Keep meticulous records of all property-related activities, expenses, and income.
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Be clear about intent: How you treat the property matters, but so does your documented intention for acquiring it.
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Structure holdings wisely: Consider creating separate entities for different types of properties.
Understanding which properties don’t qualify as investment properties is crucial for any real estate investor. The distinctions may seem technical, but they have real financial consequences.
The main takeaways:
- Primary residences generally don’t qualify as investment properties
- Properties held as inventory (flips, developments) don’t qualify
- Domestic-to-foreign exchanges don’t qualify for 1031 treatment
- Business interests (except DSTs) don’t qualify
- Proper documentation and activity levels are essential
I’ve seen too many investors make costly mistakes by assuming their properties qualified for certain tax treatments when they didn’t. Don’t be one of them! When in doubt, always consult with a qualified tax professional who specializes in real estate.
Remember, the rules can be complex, but with proper planning, you can structure your real estate activities to maximize tax advantages while staying compliant with IRS regulations.
Have you had any experiences with properties that surprisingly didn’t qualify as investments? I’d love to hear your stories in the comments!
Rental real estate guidance
According to the IRS, for purposes of the 199A deduction, an enterprise is a trade or business if it qualifies as such under Internal Revenue Code Section 162. That section doesn’t expressly define “trade or business” — it’s determined on a case-by-case basis based on various factors. Generally, a trade or business is an activity conducted “on a regular, continuous and substantial basis” with the aim of earning a profit.
Uncertainty over whether rental real estate qualifies, especially for taxpayers with one or two properties, prompted the IRS to issue Revenue Procedure 2019-38 to establish a safe harbor. Under the Revenue Procedure, a rental real estate enterprise (RREE) is deemed a trade or business if the taxpayer (you or a “relevant pass-through entity” in which you own an interest):
- Maintains separate books and records for the enterprise,
- Performs at least 250 hours of rental services per year (for an enterprise that’s at least four years old, this requirement is satisfied if you meet the 250-hour test in at least three of the last five years),
- Keeps logs, time reports or other contemporaneous records detailing the services performed, and
- Files a statement with his or her tax return.
The Revenue Procedure lists the types of services that count toward the 250-hour minimum and clarifies that they may be performed by the owner or by employees or contractors. It also defines an RREE as one or more rental properties held directly by the taxpayer or through disregarded entities (for example, a single-member LLC).
Generally, taxpayers must either treat each rental property as a separate enterprise or treat all similar properties as a single enterprise. Commercial and residential properties, for example, can’t be combined in the same enterprise.
There may be opportunities to restructure rental activities to take full advantage of the safe harbor. For example, Marilyn owns a rental residential building and a rental commercial building and performs 125 hours of rental services per year for each property. As noted, she can’t combine the properties into a single enterprise, so she doesn’t pass the 250-hour test.
But let’s say she exchanges the residential building for another commercial building for which she provides 125 hours of services. Then she can treat the two commercial buildings as a single enterprise and qualify for the safe harbor (provided the other requirements are met).
Are you a real estate professional?
Ordinarily, taxpayers who “materially participate” in a trade or business are entitled to deduct losses against wages or other ordinary income and to avoid net investment income tax on income from the business. The IRS uses several tests to measure material participation. For example, you materially participate in an activity if you devote more than 500 hours per year, or if you devote more than 100 hours and no one else participates more.
Rental real estate, however, is generally deemed to be a passive activity — that is, one in which you don’t materially participate — regardless of how much time you spend on it. There’s an exception, however, for “real estate professionals.”
To qualify for the exception, you must spend at least 750 hours per year — and more than half of your total working hours — on real estate businesses (such as development, construction, leasing, brokerage or management) in which you materially participate. (The hours you spend as an employee don’t count, unless you own at least 5% of the business.)
Why Your Rental Property Isn’t Making Money
FAQ
What qualifies as investment property?
… a property that’s not your primary residence and is purchased or used to generate income, profit from appreciation, or take advantage of certain tax …
Which type of property does not qualify for a 1031 exchange?
What are the 7 types of investment?
- Equities (otherwise known as stocks or shares)
- Bonds.
- Mutual Funds.
- Exchange Traded Funds.
- Segregated Funds.
- GICs.
- Alternative Investments.
What does IRS consider investment property?
Investment property is purchased with the intent (or hope) of profiting from its sale. Stocks, bonds, collectibles, and land are typical investment properties.