Pass-Thru Deduction, Landlords, New Regs

[John Hyre]

                                                                            Panic! Landlords Cannot Take New Pass-Thru Deduction! NOT.

The IRS just came out with proposed regulations on the awesome new Pass-Thru Deduction. The regulations are over 100 pages long. Expect more commentary from me on how they affect REI and SDIRA's. Here, we'll discuss whether rental properties are a "trade or business". That's a very important subject, because if the rentals are "merely an investment activity" and "not a trade or business", then the Pass-Thru Deduction does not apply to them.

For those of you who are not familiar with this deduction – you really should be. It is the most small-business friendly legislation ever passed and allows most business owners to write off up to 20% of their business’ net income. For example, if a business had net income of $100,000, this deduction allows it to write-off $20,000.   If you want more information, see the 8-hour webinar I did with Dyches Boddiford here: http://iralawyer.com/boddifordhyrewebinar/

Back to the proposed regulations:

1) First, the regulations are proposed. They may change based on public commentary. They are not yet law.

2)Second, they gave us a nice freebie: If you rent a property to your trade/business, then that rental property is considered a trade/business. For example, if I rent a property to my tax practice, that property is considered a trade/business (whether or not it otherwise would have qualified as such) and may be eligible for the deduction.

3)Third, they tell us that to determine what is a “trade or business” (I am just going to use the term “business” from now on), we can only look at law under Code Section 162.

So what does #3 mean?

Before the regulations, we were pretty certain that existing case law meant that most rentals qualified as a “business”, which is the first step to qualifying for the Pass-Thru Deduction. The case law (including both “Section 162 case law” and especially “non-Section 162 case law” pretty much said the following:

1) Work performed by others for you counts towards determining whether or not you have a business. That’s an important ruling, because whether or not rentals are a business largely depends on the level of activity involved. If your manager’s/contractors’/employees’ activity counts towards “activity”, then it is much easier to qualify as a business.

2) One rental could be a business all on its own if it was not extremely passive

3) Multiple rentals would generally qualify as a business

4) Triple net lease properties probably do not constitute a business

By looking at only Section 162 case law what would the new regulations change?

Not much. The courts would likely arrive at the same conclusions described in 1 – 4, above. The “non-162 case law” still counts indirectly. That’s because those cases were decided based on the same language and principles of Section 162. And judges like to borrow from existing case law that is similar to what they are deciding – it is both easier than reinventing the wheel and tends to appease their preference for consistency.

Now could a judge decide to make up brand new law for deciding if rentals are a business for purposes of 162? Sure. It is just not likely. That’s not how the Tax Court tends to operate – very much the opposite. But the regulations, in the name of clarity, did add some grey to what we thought was a slam dunk, namely, that rentals are generally a business.

Of course, the analysis above assumes that these future cases will ever see a courtroom. Very few, if any, shall in fact make it that far.

When an audit ends badly, a taxpayer can sue in Tax Court. 97% (or so) of the cases that go to Tax Court settle – and in the vast majority of cases, the settlement favors the taxpayer. Why? Because the IRS attorneys only want to go forward with cases that are a slam dunk, black & white win for them. If there is grey involved, they tend to settle. In my experience over the last 23 years, those settlements are usually pretty favorable for taxpayers.

Sidebar: You have a strict 90-Day deadline to sue in Tax Court. That deadline starts ticking the day a Notice of Deficiency (results of the audit) are sent to you. Do not procrastinate. If an audit goes bad or is going bad, get a hold of me ASAP. I take these cases nationwide, especially if RE or SDIRA’s are involved, and I will often do so on a contingency (you pay only if I knock the tax down) basis. OK, back to our regularly scheduled programming.

What is your risk for taking a "grey" position, such as "My rentals are a business and qualify for the Pass-Thru Deduction"? The risk is that if you are wrong, the will have to pay the tax "you should have paid" with penalties and interest. The penalty is usually about 20% of the taxes you tried to save. The interest is around 4% APR.

There are three ways around the penalties:

1)Sue in Tax Court. Settle. By far the most common outcome. Will the IRS waive penalties to avoid litigation of something this grey? Very likely, I see it frequently, and in cases that the IRS had a much better chance of winning.

2)Sue in Tax Court. Win. And on these grey questions of “are your rentals a business”, prior rulings favor the landlord. As I mentioned, the IRS is unlikely to actually litigate any but the most favorable cases.

3)Sue in Tax Court. Lose with Substantial Authority. Unlikely. But even if a judge rules that your rentals are not a business, you can still get the penalties waived by proving that the issue was grey (it is) and that you had “Substantial Authority” for thinking it was a business. In English, “Substantial Authority” means a good argument backed by some law. And that much, in my subjective but informed opinion, we do have.

Likely worst case for landlords who own more than one unit and those units are not on triple net lease: You owe the taxes saved via having taken the Pass-Thru Deduction, you avoid penalties on those taxes, and owe interest on the taxes saved via having taken the deduction at a circa 4% APR. More likely: You get some or all of the deduction via settlement. Most likely: You get the entire deduction and are never audited, or if audited, still get the deduction.

If you are a landlord with more than one unit and those 2+ units are not triple net leased, will I represent you in Tax Court on a contingency basis? Very likely.

Note: Even if you only own one rental unit, you probably still have a business if you are not completely passive about managing it.

Bottom line: The tax law favors you in most grey situations, and this situation does not strike me as all that grey. If you have more than one unit and those units are not triple net leased, take the deduction. If you have one unit but actively manage it, take the deduction. The odds favor you by a large margin.

[John Hyre]

Posted elsewhere as well - but worth reading for the research shared & citations posted:  

Natalie wrote “It's more a wave on information from someone whose business is defending things in court.”

Dunno what a “wave on information” means. It would seem that you are attempting to dismiss what I wrote based on what I do for a living as opposed to addressing what I actually wrote. If so, you have engaged in an ad homenim approach. I hope I am mistaken – have I misunderstood what you wrote?

For the record, about 85% of my time is spent on planning for REI and SDIRA owners. About 15% is spent in audits, Tax Court, or fighting IRS collections. I used to prepare returns. I presently do not, though I may re-engage in the future. Bottom line: I get the system and how things actually work. Not just what is written, but how things work in….practice.

Natalie wrote: “I still think it's blindly optimistic that the IRS would qualify someone owning 1 rental as a business”

“Blindly optimistic” …. needlessly strong words that reflect on my credibility…..or yours. Any support for them?

While I care what the IRS “thinks”, I am much more concerned with what the law actually is. Sometimes what the law is and what the IRS “thinks” are not the same thing. If one were to limit oneself to what the IRS “thinks”, then one’s clients would not fully benefit from what the law actually permits.

In the John D. Fackler [45 B.T.A. 708 (1941)] case, the BTA held that a (singular) rental is automatically a TB.

The BTA ruled that “where the owner of rental property devotes it rental purposes and exclusively to the production of taxable income, the property is used by him in a trade or business”.

On appeal, the 6th Circuit came to the conclusion that the building (rented to multiple tenants) was a TB, but they got there via different means. Instead of following a blanket rule that any single rental property is a TB, they examined the level of activity and concluded that the rental property generated enough activity to be a TB. Specifically:

“The management of the property necessarily involved alterations and repairs…..it was also necessary to furnish elevator service, heat, light and water which required regular and continuous activity and the employment of labor, the buying of material and many other things which come within the definition of business”.

That was on a single building. Drop out the elevator language – does that language describe what many landlords do with just one single-family rental? Why yes, it does. And note that “the employment of labor” counts. The landlord did not do everything himself.

Let’s move to a more modern case: Balsamo (T.C. Memo. 1987-477), which involved a single-family rental. Here an interesting quote from that case:

“Our historical position that rental of one property constitutes a trade or business establishes a general not an absolute rule.”

Well, now, that’s interesting. The Tax Court says that the general rule is that one property constitutes a TB, but that they will look at facts & circumstances to see if the general rule should apply. Hmmm, my position that a single rental property – even a single-family – could be a TB isn’t sounding so “blindly optimistic” all of a sudden, is it?

In this case, the taxpayer inherited a property. The court looked at her activities and stated the following (parentheticals are mine):

“Petitioner (that is, the taxpayer) owned the premises for a very short period. Based on the incomplete and disjointed record before us, it appears that petitioner's principal activity with respect to the premises was to negotiate and carry out its sale. Petitioner's activities with respect to the premises as rental property were almost non existent. Petitioner testified that the lessee, Economopoulos, pointed out to her a dead rat, a bee's nest, and several leaks during her single visit, yet petitioner presented no evidence that she attempted to remedy these problems during her period of ownership. Petitioner testified that her brother-in-law performed various repairs on the premises on two separate occasions. However, Economopoulos, a credible and disinterested witness, had no recollection of such visits (that’s the Court’s way of saying “she is lying”), nor could petitioner produce a paid receipt for his services. She also did not deduct these expenses. She took the premises subject to the lease and let the status quo continue during her period of ownership. The foregoing would indicate that petitioner did not perceive the property as rental property, but as investment property shortly to be sold to Economopoulos.”

In short – if she’d have had more activity, the single rental could have been viewed as a trade or business. This principle has stood since at least the 1940’s and is most unlikely to change now.

Natalie said: “as well as qualifying someone who has all their properties managed as a business.”

As to qualifying even though someone also manages the properties……see Gilford, 201 F.2d 735, 2nd Circuit (1953). See also Murtaugh, T.C. Memo. 1997-319. In both cases, delegated activity explicitly counted in determining that delegated activity “counted”. Murtaugh was especially fun. It involved rental of a time share via the management company that sold the time share to the taxpayers and screwed the taxpayers by renting their units (predictably) last.

Here’s some relevant language from Gilford:

“Although it does not appear that the * * * [taxpayer] did anything herself in connection with the management of these * * * buildings, an appreciable amount of time and work was necessarily required on the part of the managing agent. And if such management was a "trade or business," the * * * [taxpayer] was so engaged although she acted only through an agent.”

Passive indeed.

Here’s some language from the Murtaugh case:

“The principle of Gilford was more recently reaffirmed by this Court in Whyte v. Commissioner, T.C. Memo. 1986-486 n.22 ("It is well settled that where an agent is acting on behalf of an owner in managing a business, the owner is still considered to be engaged in a trade or business." (Emphasis added.)), affd. 852 F.2d 306 (7th Cir. 1988).”

and

“We believe the record in this case, although sparse, establishes that B'Mae's (the management company) was acting as petitioner's agent when it undertook the various activities incident to renting out the timeshares. Petitioner's (taxpayer’s) uncontroverted testimony was that B'Mae's undertook the advertising, guest registration, housekeeping, and inventory replenishment in exchange for a fee equal to 40 percent of the proceeds of any rentals. Documents in evidence substantiate this fee arrangement.”

and (bold & underlining mine)

“In both Grier v. United States, supra , and Balsamo v. Commissioner , supra , neither the taxpayers themselves nor their agents had been sufficiently active with respect to the real property involved to be engaged in a trade or business. In Gilford v. Commissioner, supra , the agents were actively involved in managing commercial real property, to a sufficient degree to be engaged in a trade or business. In the present case, the transient rentals of petitioners' property likewise entailed sufficient activities to constitute a trade or business, and while these activities were conducted by B'Mae's, they are attributable to petitioners for purposes of determining whether petitioners were engaged in a trade

or business.”

Again, that the taxpayer was “passive” did not matter. Delegation “counts” for examining activity levels.

Natalie said: “It generates passive income…… You don't qualify as a RE pro in term of hours.”

Code Section 469 (Passive Activity Losses) is irrelevant to TB discussion under Section 162.

Natalie said: “You pay no self employment tax”

Code Section 1402 (Self Employment Tax) is irrelevant to TB discussion under Section 162.

Finally: Some of the cases I have cited decided what’s a “trade or business” under sections other than 162. So they are irrelevant, right? Not so fast.

As I mentioned elsewhere, the term “trade or business” has been consistently used throughout the Code. The cases cite each other even when a different Code Section is involved. The reasoning does not change at all, regardless of which section is in play. The Tax Court hates making up new law and likes to borrow from existing law.

Here’s an interesting quote from a law journal article written in 1955 (“The Single Rental as a ‘Trade or Business’ Under the Internal Revenue Code,” U. of Chi. L. Rev. 111 (1955) – talk about a relevant title.

“The courts apparently agree that the meaning of the words "trade or business" is uniform throughout the Code provisions here considered…No court has made an explicit distinction between a "trade or business" authority under one section of the Code and another under a different section. On the contrary, the courts cite indiscriminately any case having to do with "trade or business" whether under

Section 1221, 1231, 165 or 162.”

Plus ça change, plus c'est la même chose.

The above represents part of my research. I spent around 15 hours in December & January answering the question of “When are rentals a Trade or Business”.

Whenever possible I do my homework. I do like to sometimes post to see I am full of it. Like anyone else, I am sometimes off or flat out wrong. And I appreciate being shown to be off or wrong in the spirit of informed debate and intellectual honesty. I do get peeved when people get needlessly personal or resort to unfortunate short cuts.

I will post links to references cited as well as a few other useful cases & articles.

Bottom line, as I stated before (and still open for logical refutation, I want to know if I am in fact mistaken):

- Most taxpayers with 2+ rentals that are not triple-net leased should qualify as a TB

-Many taxpayers with 1 rental that is not triple net leased may qualify

-Delegation counts, even if the taxpayer is completely “passive”

-Pass-through from partnerships/S-Corps/certain kinds of trust should count