How to determine if Rented for Profit

8 Replies

Is depreciation part of the calculation to determine whenther a property is rented for profit or not ?  The IRS says a profit exists if "your rental income is more than your rental expenses" -- but is depreciation considered a rental expense ?

Depreciation can be very high which makes the profit test difficult to achieve.

Many kind thanks for an answer

Lawrence Kaplan

Marlborough, MA, USA

Originally posted by @Lawrence Kaplan :

Is depreciation part of the calculation to determine whenther a property is rented for profit or not ?  The IRS says a profit exists if "your rental income is more than your rental expenses" -- but is depreciation considered a rental expense ?

Depreciation can be very high which makes the profit test difficult to achieve.

Many kind thanks for an answer

Lawrence Kaplan

Marlborough, MA, USA

 Absolutely not.

There are markets where expenses ( without depreciation are far greater then rent, and it is still Rental activity. 

It’s about you intention. If you rented a property even to your kids at fair market rent, that is still considered a for-profit activity. 

You will get in trouble if you rent well below market and you don’t have any explanations. IRS is pretty reasonable. 

Originally posted by @Lawrence Kaplan :

The IRS says a profit exists if "your rental income is more than your rental expenses" 

Where did you see this phrase?

The IRS, in fact, states here:

If you don't use the rental property as a home and you're renting to make a profit, your deductible rental expenses can be more than your gross rental income, subject to certain limits. 

@Lawrence Kaplan Depreciation is an expense as far as the IRS and taxes are concerned. But it id not an expense when considering whether a property is profitable to you ie: money in our pocket. That is why depreciation is sometimes called a "Paper loss". You loss  money on paper but not in real life. This can save you taxes. 

Now lets talk longer run, The fact is your property IS wearing out. The roof is going to last 20 years a water heater will last 10 years etc. If a water heater is $600 installed and it lasts 10 years it is costing you$60 a year. You don't see that cost for 10 years but it is real. In the business they are called capital expenses  (cap ex). This is an important point that many investors don't consider when evaluating deals. 

Capital expenses may not come for several years if you are buying a new or renovated property. However when they do come they are expensive items. You need to account for this.

Originally posted by @Lawrence Kaplan :

Thanks all.

Michael, I was quoting from IRS pub 527 page 16 chapter 4 "not rented for profit". The rules are quite draconian if you don't pass the 3 out of 5 year test...

Larry

Ah, now I know where the confusion comes from.

Luckily, you simply misinterpreted this IRS rule, as do 99% of people who read it. (The other 1% is accountants and lawyers.) 

The key word you missed was "presumption." What it means is that if you show more income than expenses for 3 out of 5 years - the IRS will not question if you rented for profit, because it will be automatically presumed to be the case. It does not mean that you must show it, though!

It only means that in all other cases (cannot show positive income for 3 years) you must prove to the IRS that you rented it for profit - IF they raise an objection. Having losses on rental properties is absolutely normal in this business, and the IRS is perfectly aware of it. This "not for profit" conversation only comes if the pattern is really suspicious. For example, you have minimal rent for 3 years in a row, with very large expenses. Even then, you may be able to defend your "for profit" intention, depending on the circumstances.

An analogy: if you wear a police uniform and carry guns - you are presumed to be a legitimate cop (other than in a Terminator movie). Everyone else may need to show his badge to prove his law enforcement status.

As a curious aside, I wonder how the IRS will hereafter (subsequent to the new tax laws) treat "not for profit" situations.  Given that the miscellaneous itemized deductions on Schedule A are no longer available, it would seem that expenses (other than real estate taxes and mortgage interest) can no longer be deducted to offset income.  It will be interesting to see how the IRS rewrites this section for the 2018 version of pub 527.

Many thanks Michael.  I am impressed and admittedly amazed at how responsive experts on on this message board.

I am going to post more about my situation in a separate thread,

Thanks again to all,

Larry Kaplan

Marlborough, MA