Bad News for Buy and Hold Residential Investors

[Brian Schmelzlen]

For the past 8 months, tax professionals have been studying Section 199A (the 20% pass-through business deduction) and trying to position their clients to best be able to maximize their deduction.  However, we have been operating without any regulations providing guidance on how the deduction will operate.

Because of last minute changes made to the Tax Cuts and Job Act (the 2017 tax reform law), many assumed that rental real estate would qualify for the Section 199A deduction.  However, that was just an assumption, and yesterday the IRS finally issued proposed regulations providing clarity.  The bad news: under these proposed regulations most rental activities will not qualify.

Here is the problem: the deduction applies to qualified business income from a qualified "trade or business".  We were waiting to hear how, for purposes of Section 199A only, the IRS would define a trade or business.  Rather than coming up with a new definition that would be helpful for real estate investors, they decided to use Section 162 of the Internal Revenue Code to define it.

There has been quite a few court cases over the years defining a "trade or business" under Section 162, and in a lot of cases rental real estate does not qualify.  The courts will look at a lot of factors, but to oversimplify things if you report the activity on Schedule E of your individual tax return rather than on Schedule C, it doesn't count.

Now, some of you may be wondering about if you own a significant number of rental properties and operate them like a business.  Even in that case it probably won't help.  The issue is that the IRS indicated that each property would be evaluated independently, not in the aggregate, so having more properties doesn't help.  Additionally, the IRS did not provide an exception for those it classifies as real estate professionals.

There is one carve-out, and it is for self-rentals.  If a business is renting property, and there is a common owner to both the business and the property, that activity qualifies for the deduction.

So, this is bad news for buy and hold investors.  However, it is not bad for all real estate investors.  My understanding is that flippers and short-term vacation rentals (that operate more like a bed and breakfast, rather than a pure rental) will still qualify for the deduction. 

[Brandon Hall]

After spending the weekend diving into the regs, I take the same position as @John Hyre does. And it's far from an aggressive stance. 

In fact, I feel a lot of what has been said here, such as (paraphrasing) "all Sch E rentals are disqualified" and "rentals generate passive income [thus they don't qualify]" and "you [need to] pay self-employment tax" are statements that are overly conservative and potentially misguided. I hope investors and CPAs don't blindly follow such conclusions as it will lead them to harm (as in paying more tax than they should). 

Can a single rental qualify as a trade or business per Sec. 162? 

A single rental can most certainly qualify as a trade or business under Sec. 162. Note that a "single property" is not the determining factor for what constitutes a trade or business. There are many court cases that carve out what a trade or business is related to the rental of real property. There are also several that explicitly deal with one property. The court cases/memos you should educate yourself on are as follows:

Fackler v. Commissioner, 45 B.T.A. 708 (1941) -- John already pointed this out. 

Hazard v. Commissioner, 7 T.C. 372 (1946)

Gilford v. Commissioner, 201 F.2d 735 (2d Cir. 1953)

Post v. Commissioner, 26 T.C. 1055 (1956)

Schwarcz v. Commissioner, 24 T.C. 733 (1955)

Elek v. Commissioner, 30 T.C. 731 (1958)

Fegan v. Commissioner, 71 T.C. 791 (1979)

Curphey v. Commissioner, 73 T.C. 766 (1980)

Balsamo (T.C. Memo. 1987-477) -- John already pointed this memo out. 

How does qualifying as a real estate professional help me?

As @Natalie Kolodij previously stated and then appeared to walk back on in a later post (or maybe I'm confused), qualifying as a real estate professional under Sec. 469 does not automatically qualify your rental activities as a trade or business under Sec 162. Conversely, not qualifying as a real estate professional under Sec. 469 does not mean that your rentals cannot rise to the level of a trade or business under Sec. 162.

We also have this little snippet on Pg. 44 of this  IRS Pub:

Additionally, section 469 is a loss limitation rule used to prevent taxpayers from sheltering passive losses with nonpassive income. The section 199A deduction is not based on the level of a taxpayer’s involvement in the trade or business (that is, both active and passive owners of a trade or business may be entitled to a section 199A deduction if they otherwise satisfy the requirements of section 199A and these proposed regulations).

Do I need to pay Self-Employment Tax on my rental income?

Gosh no. Not even for short-term rentals unless you are providing substantial services. Self-Employment taxes are seen in Sec. 1402 which is irrelevant to Sec. 162 (as John already stated in his post). 

When will my rentals qualify and not qualify for the deduction?

Interestingly, I haven't seen Sec. 199A(c)(3)(A) discussed in a BP thread yet. Sec. 199A(c)(3)(A) states --

(A) IN GENERAL.—The term ‘qualified items of income, gain, deduction, and loss’ means items of income, gain, deduction, and loss to the extent such items are— 

   (i) effectively connected with the conduct of a trade or business within the United States (within the meaning of section 864(c), determined by substituting ‘qualified trade or business (within the meaning of section 199A)’ for ‘nonresident alien individual or a foreign corporation’ or for ‘a foreign corporation’ each place it appears), and 

   (ii) included or allowed in determining taxable income for the taxable year. 

Sec. 864(c)(2) tells us there are two factors as to whether income is "effectively connected" to a U.S. Trade or Business:

1. Whether the income is derived from assets used in the business.

2. Whether activities of the business are a material factor in realizing the income. 

In court cases where Sec. 864 has been addressed, mere ownership of rental real estate does not constitute the carrying on of a trade or business (Neill v. Commissioner, 46 B.T.A. 197 (1942)). Taxpayers must do more, such as: collecting rent, paying expenses, hiring contractors, entering into leases, etc (De Amodio v. Commissioner, 34 T.C. 894 (1960)). 

As you can see, the test for a rental being a "trade or business" and a rental being "effectively connected" appears to be the same, if not eerily similar.

In Sec. 469, we see similar language in that a taxpayer qualifies for the special $25,000 allowance if they actively participate in the rental activity. And to actively participate, the taxpayer needs to make management decisions like entering into leases, approving tenants, coordinating repairs, hiring contractors, etc. 

It appears that as long as a taxpayer actively participates in the rental activity, then the net rental income will be effectively connected to a U.S. Trade or business for purposes of Sec. 199A. Therefore, a single rental property would qualify as long as the net rental income is effectively connected to a U.S. Trade or Business. 

I agree with the sentiment that NNN leases will not qualify as they often are not effectively connected with a U.S. Trade or Business. The big question is whether a taxpayer can rise to the level of a trade or business when a property manager manages the rental activity for the taxpayer. You will need to apply the facts and circumstances to make a determination for your client, but as of right now, there are no hard and fast rules.

As others have stated - hoping for some form of safe harbor that allows us to classify rentals automatically as a trade or business. Regardless, my firm will continue classifying most of our client's rental activities as qualifying trades or businesses. 

Crap! My CPA/EA/Tax Pro said that my rentals aren't a trade or business - should I fire them?

Not so fast. We're expecting further guidance to be released. Hopefully, a safe harbor will be added into the code or the temp regs will be better defined as it pertains to rental properties. Stick by your tax guy (or gal) because this crap is tough!

But if your CPA/EA/Tax Pro is auto-defaulting to "all rentals are passive, not a trade or business, and no QBI deduction," you should absolutely ask them to substantiate their opinion with authoritative sources. And then you should point them to this thread :)