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.