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.

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Kenneth Blacow

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Peachtree City, GA

Kenneth Blacow

Pro Member

Peachtree City, GA

Replied August 26, 2018 20:55

@John Hyre, what is your opinion on modified gross leasing? I am a general partner in an LP that holds a 5 unit commercial building that uses a modified gross lease not NNN. I found the article below that says to switch to a MGL instead of NNN. I am very involved with the manafment company and the bookkeeper in management decisions. I would think this would qualify as a TB.

https://daveison.com/real-estate-owners-is-it-time-to-switch-from-a-triple-net-lease/

Kenneth Blacow

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John HyrePoster

Accountant / Attorney
San Juan, PR

John HyrePoster

Accountant / Attorney
San Juan, PR

Replied August 27, 2018 03:58

So what is a modified gross lease?

If it still boils down to NNN lease just via different language, then the IRS will look at the substance of the transaction and rule that NNN is NNN no matter what you call it. On the other hand, if one moves away from NNN and the new lease resembles the more standard arrangement where the landlord is much more active (even via its managers), then they might be on to something.

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Baselane