I am very happy to be returning to Indiana this year to teach the two-day Federal Tax Update course. This year we have a lot to cover, including: the long-term impact of the Tax Cuts & Jobs Act, all the clarifications and changes related to recent regulations and rulings for the Qualified Business Income Deduction, Opportunity Zones, and multiple new cases, rulings and regulations in several areas of individual and business tax law. One area of particular interest is how the QBI deduction can be used for rental real estate activities. See the article below for the most recent info, and come see me this winter for all the latest on this and many, many other developments. See you soon!
Qualified Business Income (QBI) Deduction and Rental Real Estate
Historically, the tax consequences of whether or not a particular rental real estate activity was a trade or business activity were minimal. Income from rental real estate is not subject to SE tax regardless if the activity is a trade or business (§1402(a)(1)). All rental related expenses are deductible under either §162 (trade or business) or §212 (investment). However, the Tax Cuts & Jobs Act created the Qualified Business Income deduction (QBI or §199A deduction), which provides a deduction equal to 20% of net qualified trade or business income, including real estate rental activities that are deemed to be trade or business activities. The problem is the Internal Revenue Code does not define when a rental real estate activity rises to the level of a trade or business activity and the recently finalized regulations fail to provide definitive guidance. In the Summary of Comments and Explanation of Revisions section of the regulations (SCER), the IRS noted that the rental of a single property that requires regular and continuous involvement may qualify as a trade or business. But the IRS also opined that the rental of a single piece of property does not rise to the level of a trade or business in every case as a matter of law. Essentially, tax professionals have been left to derive their own conclusions in each situation based on IRS guidance and court cases—in other words, the facts and circumstances of each rental activity must be assessed in order to determine whether a particular rental activity satisfies the trade or business activity requirement.
"Practitioners may be tempted to look to other code sections for guidance, such as the passive activity rules (especially the material participation rules) to assist in QBI decisions. This would be a huge mistake."
Caution: Can §469 or §1411 help?
Practitioners may be tempted to look to other code sections for guidance, such as the passive activity rules (especially the material participation rules) to assist in QBI decisions. This would be a huge mistake. The SCER section of the final QBI regulations make it clear that the passive rules serve a very different purpose than the QBI deduction and thus should not be relied on in any way when making decisions about QBI (SCER ll.A.3.a.). Some practitioners may also wish to rely on the net investment income tax rules to help define trade or business activities. However, the NII tax applies to passive activities, regardless if the passive activity is an investment or trade or business. In other words, you could have a rental activity that is subject to NII tax and still qualify as a trade or business for QBI purposes.
So what do the courts say? (P. Groetzinger v. Comm., 480 US 23, S.Ct. 980, Feb. 24, 1987)
In Groetzinger, which is the seminal case in this area, the Supreme Court noted that the determination of whether or not an activity is carried on as a trade or business must be made for each activity using the specific facts and circumstances of that activity—there is no bright line test. Furthermore, the Supreme Court held that the four most important factors to be reviewed to make such determination are whether or not the activity is pursued:
- On a full-time basis
- With regularity
- For the purpose of making a profit
While all four of these factors are not required, the more factors that are met the more likely the activity is carried on as a trade or business.
Some other cases to note:
- Murtaugh, James B. v. Comm., TC Memo 1997-319 where taxpayer who used a property manager to rent two timeshare interests was found to be in a trade or business.
- Gilford v. Comm., 201 F.2d 735 (2d Cir. 1953) where taxpayers with fractional interests in real estate rentals and who had no involvement other than hiring a property manager were treated as being in a trade or business. The underlying work of the property manager elevated the activity to the level of a trade or business regardless of the taxpayer’s involvement.
But also see:
Grier et al. v. U.S., 120 F. Supp. 395 (1954) USDC D. Connecticut) where taxpayer inherited single family home, rented it for 12 years to the same tenant, and then sold it. Court ruled the taxpayer did not have enough activity to make the rental a trade or business.
IRS adds their own guidelines (§1.199A Regs, Summary of Comments and Explanation of Revisions (SCER) Section ll.A.3.b.)
In the SCER section of the final QBI regulations the IRS noted that the factors to be considered when determining whether an activity is a trade or business include: a) type of property rented; b) number of properties rented; c) level of an owner(s) or agent(s) day-to-day involvement; d) ancillary services provided by lease; and e) the lease term (e.g. long-term vs. short-term).
Regulations provide guidance in two instances of rental activities
- Rentals as a trade or business safe harbor
Self-rentals are a trade or business (§1.199A-1(b)(14))
Rent or licensing of tangible or intangible property (rental activity) will be treated as a trade or business for QBI purposes if the property is rented or licensed to a trade or business conducted by the individual or a relevant pass through entity (RPE) which is commonly controlled (as defined by §1.199A-4(b)(1)(I)).
Real Estate Trade or Business Safe Harbor (Notice 2019-7)
This notice creates a safe harbor that taxpayers may rely on to establish that a rental real estate activity is a trade or business solely for purposes of the QBI deduction. The safe harbor may be used by individuals and relevant passthrough entities (RPEs) (i.e. S corporations, partnerships and some estates and trusts).
This is only a safe harbor. Failure to satisfy the requirements of the safe harbor does not preclude a taxpayer from otherwise establishing that a rental real estate activity is a trade or business for QBI purposes. Taxpayers may always rely on their own facts and circumstances to establish that an activity is a trade or business.
Form 1099 Trap!
One last comment—the IRS specifically said in the its Summary of Comments in the final QBI regulations that “ taxpayers should consider the appropriateness of treating a rental activity as a trade or business for purposes of §199A where the taxpayer does not comply with the information return filing requirements under §6041." They are referring to Forms 1099. The penalty for not filing 1099s can be as much as $1,060 per 1099. Ouch!
Ron Roberson will be presenting his 2-Day Federal Tax Update in Carmel on January 9-10, 2020 in Carmel.