All Forum Posts by: Brandon Hall

@Justine Scheuher I'm with everyone else in that your partner should receive a pretty low stake, or just pay your partner for services rather than give away equity. 

When you form a partnership, as an LLC, you can differentiate between capital interests and profits interests. It could be that you and your partner are putting in equal amounts of money, and therefore your capital interests are equal. But maybe you own 90% of the profits interest and your partner only owns 10% because you're going to be managing the deal and the profits will largely be based on your know-how.

When you sell, you'll split the proceeds per your capital interests, or 50/50 in this case. But during all the years you held the property, you received a 90% of the profits. 

Anyway, just a thought!

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 :)

Super pumped to be part of the team. It’s a cause I can easily connect with as military runs in my family. When Jay asked if I wanted to be on the team, I was more than happy to have our firm, The Real Estate CPA, dedicate resources to handle A Hero’s Home Inc’s tax and financial matters.

Thank you to everyone who has supported us so far. The community response is exceeding our expectations!

@Katie Thomas thanks for the tag - I haven't updated that podcast episode but I should.

The “7-day rule” that I referred to is found in Temp. Reg. §1.469-1T(e)(3)(ii)(A). It states that an activity is not a rental activity if the average period of use of the property is 7 days or less. 

There is a second rule that says states that an activity is not a rental activity if the average period of customer use of the property is 30 days or less and significant services are provided. (Temp Reg. §1.469-1T(e)(3)(ii)(B))

If the rental is not a rental activity, it should not be reported on Sch E. Instead, it should be reported on Sch C. But just because a rental activity is deemed not to be a rental activity for purposes of the passive loss rules doesn’t necessarily mean that a profit from such activity is subject to self-employment tax due to the exclusion of rental income from SE tax (IRC §1402(a)(1)). 

The question would then become whether the property owner is considered to be a real estate dealer or provides substantial services. If so, and your rental is deemed not to be a rental activity, you may have SE income. 

The penalty is a failure to file penalty. Partnership tax returns are due on 3/15, not 4/15.

There should be a number in the upper right hand corner of the notice you received. You could call that number and request a first time penatly abatement for the partnership. However understand that the “first time penalty abatement” is a silver bullet that should be used wisely.

Licensing is not a pre-requisite to prepare a tax return. All you need is a PTIN which is quite easy to get.

Agree with everything but the repairs - if the facts and circumstances allow for repair treatment vs capitalizing and depreciating, repair treatment is generally the best option regardless of income trends. The reason is due to the NPV of future tax savings vs current tax savings.

Let’s assume you have a taxpayer in the 33% tax bracket who installs a $10,000 roof and let’s just assume you can deduct as a repair (you can’t actually on residential property) rather than capitalize and depreciate. We’re talking $3,300 in tax savings today or potentially $3,300-$3,700 (assuming income trends up to the 37% bracket) in tax savings spread over 27.5 years and reduced by annual inflation. 

Option #1 seems to be the best bet.

Of course two caveats to consider are passive loss limitations and whether repair treatment will put the taxpayer at a financing disadvantage. For the latter, that’s when the 25% of us call you up ;)

Principal payments are not a deductible expense. The accounting entry would be:

Debit: Loan Payable

  Credit: Cash

No change to the P&L.

@George P. my thoughts are that this "trick" can land you in jail for tax evasion. 

@George P. the answer is “maybe” but the way he is approaching it is 100% incorrect.

You can reduce your capital gain by $250k ($500k if MFJ) via the Section 121 exclusion. To qualify, you need to live in the property for two of the last five years.

So this guy could have bought the property in 2012, moved out two years later in 2014, rented it for a couple of years and then sold it by 2017. This would allow the facts to say “of the last five years, taxpayer lived in the property as his primary residence” which would qualify him for the Sec 121 exclusion. As a result he can exclude $250k ($500k if MFJ) of capital gain.

But what you absolutely cannot do is increase your cost basis when you convert to a rental property. The basis on a rental converted from a personal residence is the lesser of FMV or adjusted basis at the time of conversion. Because of this, if the property has appreciated since purchase, you don't get to increase the cost basis to wipe out the gain.

What are the risks? Well the IRS could audit the guy and realize what he’s done. Then they can assess all sorts of fun penalties that will cost a lot in professional services to fix.

Best piece of advice: don’t take tax advise from a non-tax professional.

@Donald S. replying because that was great!

Easiest thing to do is just book the cash transfer into the LLC as a "member contribution." However, from a liability perspective, there is something to be said for loaning funds to the entity and instead booking them as a "loan from partners" but I'm not an attorney and can't speak to that point. I'm not sure how the loan affects you from a liability perspective with a SMLLC.