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Recently, the IRS released highly anticipated regulations addressing the deduction for up to 20% of qualified business income (QBI) for businesses and pass-through entities. These regulations (Section 199A) are “temporary” and will remain in place until “final” regulations are released in the future. Because these regulations are temporary, there may be additional changes coming that we cannot predict.
Overall, these temporary regulations do not adequately address the interaction of net rental income and 20% QBI deduction. We are hoping that the final regulations will offer more guidance.
Many CPAs and advisors feel that landlords will not qualify for the 20% pass-through deduction, however, we feel that this interpretation is incorrect or too conservative. The reason they are citing is that rental property does not qualify as a “trade or business” which is a requirement for the 20% pass-through deduction.
Our firm does not share such a view and instead, we are taking the position that most landlords will indeed qualify for the pass-through deduction. That said, we will not know with certainty until the final regulations are issued.
What is the deduction all about anyway?
For tax years beginning in 2018 and ending in 2025, the QBI deduction can be up to 20% of a business’s qualifying income. Qualifying income is on a net basis and must be positive. So if your rentals generate passive losses, you cannot take the QBI deduction.
Businesses that qualify are pass-through entities such as partnerships and S-corporations and sole proprietorships (including single-member LLCs).
Individuals who have taxable income of $157,500 ($315,000 for married joint filers) will begin to be phased out of their 20% deduction. Phaseout is complete when taxable income reaches $207,500 ($415,000 for married joint filers).
After being phased out of the 20% deduction due to high-income levels, we must then look at W-2 wages paid and unadjusted basis of property owned by the business ro determine the deduction. These additional steps are being referred to as QBI deduction limitations as these calculations will generally yield a smaller deduction than simply taking 20% of one’s QBI.
What is a trade or business and why does it matter?
In defining what constitutes an eligible business for QBI deduction purposes, the IRS decided to go with the Internal Revenue Code Sec. 162 definition of a trade or business, because that definition is derived from long-standing case law and IRS guidance dealing with a broad range of industries.
Unfortunately, there are no hard and fast rules detailing what a “trade or business” actually is and as a result, we have to rely on prior case law. Determining “trade or business” is going to be case-by-case based on your particular facts and circumstances.
How many rentals must you own to qualify as a trade or business?
A single rental can qualify as a trade or business under Sec. 162. 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)
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)
If I qualify for a real estate professional, will that help?
Qualifying as a real estate professional is detailed under Sec. 469 and 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).
When will my rentals qualify and not qualify for the deduction?
Sec. 199A(c)(3)(A) provides somewhat of a guiding light into how we may be able to determine if your real estate qualifies as a trade or business.
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:
- Whether the income is derived from assets used in the business.
- 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 a result, the test for a rental property being a "trade or business" and a rental being "effectively connected" appears to be the same, if not 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 for the 20% QBI deduction as the net rental income is effectively connected to a U.S. Trade or Business.
What about NNN properties or properties managed by property managers?
We take the position that properties under NNN leases will not qualify for the QBI deduction 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. Again, we’ll be looking at what activities you perform for your managed rentals on an ongoing basis. If you are totally passive and just collecting checks, there is a chance such rentals will not qualify as a trade or business and thus not qualify for the 20% QBI deduction.
We’re hoping that the IRS firms up guidance with the release of the final 199A regulations. We are especially hopeful for some form of safe harbor that allows us to classify rentals automatically as a trade or business.