Is your real estate investing activity a "trade or business" or an investment activity?

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I ask this question because there are real differences in what you are allowed to deduct, capitalize and report in these two situations.

Investors that are wholesaling and flipping are typically in the business of real estate.

Landlords typically are not in a "trade or business" as defined in the IRS code & regulations, but are engaged in an investment activity (Production of income).

Deductions that are reasonable and necessary in the production of rental income are not necessarily the same as what would be considered reasonable and necessary for a business.

A business would be allowed research and development costs, educational Seminars, trade shows, meals and entertainment. In the production of rental income you would in most cases have a tough time making a case that these were reasonable and necessary expenses.

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Yes, it is possible to enjoy the best of both worlds.

Landlords in general have passive income activity. If they actively participate in their rental activity they can take up to a 25,000 loss against ordinary income each year. The 25,000 maximum though is reduced for those whose adjusted gross income(AGI) exceed 100K $1 for every $2 that exceeds that amount. This means no loss is allowed against ordinary income for those with an AGI of 150K or more.

Keeping your business activity separate from your passive activity is extremely important. Someone flipping several properties and holding onto several properties for rentals may find that all of there income is treated as a business and they lose some of the benefits of passive activities.

Flippers are not able to do a 1031 exchange because there real estate is essentially inventory and inventory is not eligible for 1031 treatment. Flippers pay SE tax and are not limited on the loss they can take in a year. Real estate is also treated as ordinary income when it is sold rather than having special capital gains treatment.

It is extremely important to know what is a business activity and what is an investment activity. These activities must be separated or an investor may find that they are subject to unfavorable tax consequences. Often times it is 2 to 3 years after the fact that an audit may come up and if the IRS sees substantial errors in one year they usually open up several more.