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Rental Trades or Businesses and the Passthrough Deduction

Posted on Nov. 5, 2018

Rental property activities present thorny questions in applying the deduction for passthrough business income that may not be fully resolved in coming final regulations.

To qualify for the 20 percent deduction under section 199A, a partnership, S corporation, or sole proprietorship must have qualified business income from a qualified trade or business or from a real estate investment trust or publicly traded partnership. The threshold question for real estate investments is whether they constitute a trade or business. That can be difficult to answer because the case law and administrative guidance leave a large gray area.

Proposed Regulations

The proposed regulations are not particularly helpful in determining whether a real estate business qualifies as a trade or business for section 199A. The rules adopt the definition of a trade or business under section 162 on the grounds that it’s “derived from a large body of existing case law and administrative guidance interpreting the meaning of trade or business in the context of a broad range of industries.” Prop. reg. section 1.199A-1(b)(13) excludes the trade or business of performing services as an employee as well. But the case law and administrative guidance that address real estate fact patterns still leave plenty of room for interpretation.

An example in the proposed rules starts with the assumption that a taxpayer who leases parcels of land with parking structures on them to several suburban airports has a trade or business under section 199A. The example explains that the taxpayer is permitted a deduction, but that it’s limited to 2.5 percent of its unadjusted basis in the property immediately after acquisition.

Another example, in which the taxpayer merely owns parcels of land that were leased for parking lots but remained undeveloped, explains that the deduction is zero because the business didn’t pay wages or hold qualified property. At the Real Estate session of the American Bar Association Section of Taxation meeting in Atlanta on October 5, Thomas West, Treasury tax legislative counsel, said those examples weren’t written to explain the trade or business requirement, but added that it doesn’t take much activity to qualify as a real estate trade or business.

Trade or Business Precedents

The main precedent for determining whether an activity is a trade or business is Commissioner v. Groetzinger, 480 U.S. 23 (1987), which says that you need continuity and regularity of activity by the taxpayer and a profit motive. That standard leaves some uncertainty for rental activities that involve hardly any activity by the taxpayer, such as triple net leases. IRS and Treasury officials have indicated that they intend to include examples illustrating how the rules apply to some types of rental activities in the final regulations, but no one should expect rules that explain precisely what constitutes a trade or business for section 199A, nor will there be definitive rules under section 162 generally anytime soon. The best-case scenario is that the regulations will include a safe harbor for some types of rental activities and that most cases of passivity in real estate activities are permitted.

The prospect of being denied trade or business status is unappealing to rental property owners, so there is considerable interest in finding legal precedents suggesting that various real estate activities constitute a trade or business under section 199A. However, taxpayers might want to tread carefully in attempting to sweep every conceivable rental activity into section 199A, because the regulation writers are keenly aware that the real estate industry otherwise does pretty well under the Tax Cuts and Jobs Act (P.L. 115-97). The National Association of Realtors would like the final rules to always treat real property rental as a trade or business, “even if the activity does not rise to the level of a trade or business for purposes of Section 162.” That was the Tax Court’s view in the 1940s, but it’s unclear that a rule that rental property is automatically a trade or business under section 199A is consistent with the statute. (For a historical perspective, see “The Single Rental as a ‘Trade or Business’ Under the Internal Revenue Code,” 23 U. Chi. Law Rev. 111 (1955).)

In Hazard v. Commissioner, 7 T.C. 371 (1946), the Tax Court agreed that the rental of one single-family home was a trade or business because when it was sold, it was devoted to producing income, but the only activity the taxpayer seems to have done for the property was listing it for rent or sale with agents. Taxpayers with small rental operations involving only one property and limited activities might not want to rely too heavily on Hazard. In Grier v. United States, 120 F. Supp. 395 (D. Conn. 1954), aff’d per curiam, 218 F.2d 603 (2d Cir. 1955), the taxpayer inherited a house that was already rented, continued to rent it to the same tenant, and later sold it. The court determined that he didn’t have a rental trade or business. The taxpayer’s activity in maintaining the property appears to have been limited to approving estimates of repairs mailed to him by the tenants and then paying the repair bills.

Landlords with one rental property that involves minimal activity clearly aren’t the principal targets of section 199A, but excluding them from its scope merely because their operation is small potentially conflicts with the income thresholds Congress established. It appears that Congress meant to generally expand the benefit of section 199A for taxpayers that are under the thresholds, so excluding those taxpayers’ rental activities merely because of their smaller scale might be inappropriate. For example, Congress allowed taxpayers in specified service businesses to use the deduction, as long as their income is below the statutory thresholds. That’s inconclusive regarding whether rental property ownership is sufficient to be a trade or business, but it tends to favor a generous interpretation for small landlords, and perhaps particularly those with incomes under the limit.

Minimal amounts of activity were sufficient to have a trade or business in more recent guidance, but that precedent, although attractive to rental property owners, is hardly definitive. In Rev. Rul. 78-195, 1978-1 C.B. 39, the IRS allowed accounting fees and general office costs as deductible trade or business expenses under section 162 when the only activity was buying, holding, and then selling a piece of unimproved, non-income-producing real property. The ruling raises the question whether there’s a material difference between a corporation and a passthrough for finding a trade or business.

The proposed regulations add the rental or licensing of tangible or intangible property to a related trade or business to the definition of a trade or business for section 199A, even if the rental or licensing isn’t a section 162 trade or business. That addition doesn’t mean other types of rental activity can’t be a trade or business, but it also doesn’t mean all rental activity will meet the threshold. The New York State Bar Association noted that the provision might allow passive leasing activities to be included under section 199A and questioned whether Congress intended that result. It’s possible that the breadth of section 199A will be addressed more thoroughly in the coming blue book from the Joint Committee on Taxation.

Even if every real estate activity conducted through a passthrough entity can’t benefit from section 199A, the argument that many should squeeze through the trade or business requirement is reasonably strong. Congress wrote the passthrough deduction as an affirmative benefit, presumably to increase capital investment and job creation by passthrough entities. (Prior analysis: Tax Notes, Feb. 19, 2018, p. 995.) And Congress knew it wouldn’t be an inexpensive boost to passthroughs. The JCT estimated that it would cost $415 billion over 10 years (JCX-67-17). That all suggests a broader reading is more appropriate, but the statutory requirement of a trade or business must still be given effect.

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