All Forum Posts by: 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.

Here's a more complete version of what I wrote above.  I sent it out as a newsletter to my list.

                                                          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.

I think the regs gave us a safe harbor and made a previously clear issue a bit grey by restricting us to 162 case law. And yet the probabilities still favor landlords who take the deduction (with two exceptions I’ll mention below).

I think non-triple net properties have a good chance of qualifying. Even non-triple-net properties that have management outsourced.

If we include non-162 case law in the mix, the case law has been very favorable for landlords – a single rental can qualify as a trade or business and situations where more than one rental is owned consistently do well in Tax Court.

“Ah, but the regulations say that we are only talking 162 cases!” you might say. True, that. But the non-162 cases were decided on similar (really identical) principles, and judges do like to borrow from existing case law as opposed to reinventing the wheel. Why change the pattern of existing law? The identical language, identical principles, skewed outcomes in favor of landlords, and innate conservatism & huge case load of IRS litigators all push in the direction of “take the deduction”.

The idea that each rental property should “stand on its own” as a “TB” or “not-a-TB” concedes far too much. When I sell a home-study course, must that sale stand on its own as a TB or are all the sales looked at together? Why would rental properties be any different? Even if rental properties must singly “stand on their own”, the aggregation rules in the statute itself (gotta meet 2 out of 3 as Brian mentioned) seem easy for a landlord to satisfy.

A key issue: When determining activity levels, non-162 law (and maybe 162 law) counts delegated tasks as performed by the owner in the rental context. And 162 law definitely counts delegated tasks towards “activity” in non-rental contexts – why should rentals be any different? Where Mom & Pop  landlords do everything there is likely a TB. Where Mom & Pop landlords pay others to do everything….we still likely have a TB as long as activity is not near zero. Remember, exiting cases skew towards taxpayer in 162 context – and skew heavily towards taxpayer once non-162 law gets brought in.

Is there grey? Sure. But not as much as people seem to think.

Look at it from government’s perspective. 97% of cases that go to Tax Court settle. IRS lawyers like black & white slam dunk cases – and this ain’t it, not even close. Existing case law – especially if we include non-162 case law as to whether rentals are a TB – strongly favor treatment of rentals as TB unless it’s one property with a very passive owner or perhaps a triple-net lease. Odds of winning such a case are way below the threshold that IRS lawyers want to see. They’ll settle – at a minimum, penalties under 6662(a) would very likely be waived, as well they should be, given that a taxpayer likely has “substantial authority” on his side even if he loses the underlying argument.

I’d happily sign returns (with an explanation to the client that the law is grey, all the savings go to the taxpayer, as do all the costs if things head south) as well as take bad audits to Tax Court on a pure contingency fee basis in these rental cases with two exceptions I mentioned above: Taxpayer owns one property and does very, very little with it (counting delegated work as taxpayer’s work) or triple-net lease situations. In those two cases, I’d charge by the hour.

The regs changed very little for landlords.

Liz,

We have fixed any number of messes created by those people.  They do not seem to really look at a client's situation.  For example, we have seen multiple instances of C-Corps set up that made no sense when one looks at the clients' financials, returns, businesses & goals.  We have also seen them set up 401k's for client's who did not have and did not plan on having qualifying ("earned") income.  They seem interested in selling as much as possible via creation of the "fanciest" structure possible (i.e. - most expensive) and once they have the payment, follow up deteriorates dramatically in terms of responsiveness and quality.  I post this publicly - they are welcome to sue me for defamation, the discovery process would be fun.

If you were to convert some of the rentals to Airbnb, that income is usually considered "hotel" income not "rental" income. The income would then be eligible to fund 401k/IRA contributions.

Edward B, it depends on the nature of the option. There are options and then there are "options". The ones that are simply schemes for stuffing money into an IRA will not fly. Those with real money in them (say ten grand plus) and a credible narrative (i.e. - the deal would make sense if the IRS agent wanted to put $10k in it and option grantor would do the deal with anyone, not just "financial friends") can work. But the Magical options where a tiny sum of money becomes a large sum & the deal is contingent on the parties "helping each other out" will get struck down. Even with a third-party involved, options that are functionally contract assignments ($100 option to buy some third party's property) are unlikely to survive scrutiny. No skin in the game and not something on which an independent buyer would expect upside.

My conclusion as to assignments & certain types of options in IRA's will upset a number of people....heck it already has, because I've had the opinion that those transactions are not legit for quite some time now. But whether or not people like it, it is reality. IRA's have to actually invest a significant amount in an asset. Simply running one's personal services through an IRA thinly disguised as some minor asset (e.g. - contract to buy a property or an option on it, pretty much the same thing) isn't going to fly.

Not suggesting that you are in favor/against any particular type of deal or option. It's just that the large majority of "options" I've seen in IRA's are of the bogus sort - and I've seen hundreds of them. So figured I'd clarify some.