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Section 199A potentially gives real estate investors a deduction equal to 20% of their rental income.
Some real estate investor with, say, $100,000 of rental income might get a $20,000 Section 199A rental property deduction.
But a catch exists. An investor’s real estate activity must generally rise to the level of a trade or business.
Specifically, the Section 199A regulations require in most cases that a taxpayer’s real estate activity rises to the level of a Section 162 trade or business.
Unhelpfully, Section 162 (another chunk of tax law) doesn’t actually define what a trade or business is. Rather, Section 162 says taxpayers can deduct the ordinary and necessary expenses of running a trade or business–and then it and the related regulations describe the detailed rules for taking these deductions.
Nevertheless, when the Internal Revenue Service, tax accountants and tax attorneys throw around the term “Section 162 trade or business,” what they really mean is an activity that the courts and the Internal Revenue Service in past decisions count as a real trade or business that generates legitimate Section 162 business deductions.
These court and IRS decisions, by the way, all sort of work the same way. And if you happen to be interested, probably your best place to dip toes into the water is the Groetzinger v. IRS Commissioner decision.
Groetzinger summarizes nicely what a Section 162 trade or business needs to look. The activity needs to be continuous and not sporadic. And the activity needs to be conducted with regularity and with a profit motive.
And then here’s the really important point for real estate investors. The Section 199A regulations explicitly say that except in one special case situation, direct real estate investment doesn’t–does not–necessarily rise to the level of a trade or business.
By the way? The one special case situation where direct real estate investment automatically counts as a trade or business? When someone rents property to another trade or business they own at least 50 percent of.
For example, say you own an office building. Further, say you rent the office building to a corporation or partnership. If you own at least half that entity and it operates a trade or business, your rental property by law counts as a trade or business
But other than this special case, you don’t necessarily get to take the Section 199A rental property deduction just because you own property. You get to take the Section 199A deduction only when your real estate activity rises to the level of a trade or business.
Which means the $64 question is, when does real estate rental activity become a “trade or business.”
One other tangential point before we dig into the details–and just so you don’t get off on the wrong track.
Valid rental deductions inside a tax return do not automatically “create” a trade or business.
Real estate rental expense deductions–all that stuff that appears on the Schedule E page in a tax return–don’t actually count as Section 162 expenses.
The expenses count as Section 212 expenses. Section 212 expenses represent the expenses connected to “production of income,” a category of deductions that resembles Section 162 deductions. But Section 212 and Section 162 differ.
And now lets try to nail down this concept of a trade or business as it applies to rental property.
People have been arguing about what constitutes a trade or business and so for which activities a taxpayer can take a “Section 162” business deduction for decades.
In a short article for the Journal of Accountancy (available here and well worth reading), tax accountant Jennifer Spiesz and accounting professor Charles Harter summarize a handful of useful court and IRS positions on what activities rise to the level of a trade or business–and what activities don’t.
You want to look at these positions to get clarity on this trade or business stuff.
In Revenue Ruling 77-356, for example, the IRS said that a member of Congress who earned $1500 by making ten speeches over a year runs a trade or business.
Note: To adjust that $1500 figure for inflation over the roughly 40 years since the IRS published Revenue Ruling 77-356–the ruling appeared in 1977–bump the $1500 to about $6500.
Twisting that example around a bit, doesn’t that suggest that an Airbnb landlord who rents a room ten times over the year and makes a few thousand dollars also counts? I think so.
Or what about a single property landlord who rents an older home for an annual profit of a few thousand and who makes ten “house calls” over the year for repairs or maintenance issues. Does that count? To me, it seems like it does.
You have a profit motive coupled with regular activity and continuity…
In Green v. Commissioner, an individual gives blood 95 times over a year, earning money as a plasma donor.
So twisting that example around a bit, wouldn’t this example situation work too? A home owner with a large front yard, living across the street from the state fair grounds, rents parking spots 95 times to fair visitors.
This seems to me another example that shows regularity, continuity and a profit motive. (Think about what the guy’s lawn looks like after the fair ends!)
Again expounding on the examples from Spiesz and Harter’s neat and tidy article, here are some examples of activities that specifically did not rise to the level of a trade or business and then some equivalent “real estate investor” examples I whipped up.
In Langford v. Commissioner, a professor co-authors a textbook and then, though under no obligation to do so, revises the textbook five years later. That activity doesn’t count. (No continuity and no regularity, right?)
So here’s a real estate version of that sort of example. A professor on summer sabbatical to Europe (maybe to work on a textbook revision?) rents out his home. And say five years later, he again does the same thing. Does that count? I don’t think so. (No continuity and no regularity.)
In Levinson v. Commissioner, a part-time inventor patents and sells his occasional inventions. That activity doesn’t rise to the level of a trade or business because he lacks continuity and regularity.
A real estate version of this situation? Someone with a lake cabin who occasionally rents to vacationers–though not every year. Again, no regularity and no continuity… which should mean no Section 199A deduction.
Chief Counsel Advice 200321018 described a situation where a commercial fisherman gets sick and can’t fish. He therefore leases his fishing permit. The IRS attorneys said this doesn’t rise to the level of a trade or business. And arguably the fishing permit leasing action fails on all accounts to be a trade or business: No continuity, no regularity, and no profit motive.
A real estate version of this example might go like this: A homeowner gets sick and checks into assisted care facility temporarily while in recovery. Or maybe into hospice for the last months of life. He or his family rents the house while in the care facility. Again, no continuity, no regularity and no real profit motive.
In Revenue Ruling 58-112, a corporate officer earned a transaction-based fee for negotiating the sale of some company stock. The lack of continuity and regularity squelched any Section 162 business deductions.
So what about this real-estate-y example. A building owner leases his one property to a tenant on a five year, triple-net lease where the tenant takes care of all of the repairs and maintenance. In my book, this example fails: Yes, the landlord profits. And the five year lease maybe shows continuity. But negotiating a triple-net lease once every five years would seem to lack “regularity.”
In Private Letter Ruling 9106004, an asthma sufferer participated in a drug study and earned income by doing so. Here, pretty clearly, the activity probably shows continuity and regularity over the months the drug study occurs. However, surely the asthmatic’s participation in the study lacks a profit motive.
So a real-estate-y example? A handyman buys a small fixer home for a principal residence. He then renovates the home but before his family can occupy the property, surprise! His wife becomes pregnant with twins. They therefore sell the small home for profit and buy a larger home.
Arguably, the issue here would again be the lack of a profit motive: Yes, the family earned a profit. But the renovation wasn’t driven by profit.
Just between you and me? I was initially a little frustrated that the IRS regulations didn’t make it easier for us to identify what is and isn’t a real estate trade or business.
I want a bright line or simple formula.
But that admission made, past court and IRS positions provide clarity.
In fact, the basic requirements of regularity and continuity coupled with the requirement to have a profit motive work well.
One other thing to share: One of the first examples in the proposed regulations for Section 199A describes a situation where a taxpayer owns several empty, unimproved lots he leases to several suburban airports for parking.
The proposed regulation doesn’t explicitly say this situation rises to the level of a trade or business.
But the example (shown below) implicitly assumes this level of real estate activity does rise to the level of a trade or business. The investor’s real estate investing generates $1,000,000 of qualified business income, or QBI. QBI potentially leads to a Section 199A deduction:
Example 1. D, an unmarried individual, owns several parcels of land that D manages and which are leased to several suburban airports for parking lots. The business generated $1,000,000 of QBI in 2018. The business paid no wages and the property was not qualified property because it was not depreciable. After allowable deductions unrelated to the business, D’s total taxable income for 2018 is $980,000. Because D’s taxable income exceeds the applicable threshold amount, D’s section 199A deduction is subject to the W-2 wage and UBIA of qualified property limitations. D’s section 199A deduction is limited to zero because the business paid no wages and held no qualified property.
The next example in the regulations changes the scenario and says “D” actually has made improvements he’s depreciating. In that revised example, “D” gets a Section 199A deduction.
You and I shouldn’t read too much into the adjective “several” appearing twice.
But to me, the example strongly hints that someone with several rented properties and several tenants qualifies.
Two closing comments about all this stuff.
First, I think anyone serious about building wealth through real estate probably passes the “Section 162 trade or business” test. Profit motivates this person. And surely the person displays continuity and regularity in their activity.
Second, I think anyone haphazardly renting a second home or vacation property probably doesn’t qualify. Say the family loves to vacation in Florida, for example. And say you buy a condo for those vacations but then also rent the place a bit. Probably the irregular rentals to friends and the occasional stranger doesn’t display enough regularity and continuity.
Need to learn more about how Section 199A works for real estate investors? Check out this post: The Real Estate Section 199A Deduction.
And maybe check out our post about how Section 199A and Section 1031 interact, too.
And by the way: Another area where real estate investors need to be tax-savvy? The Obamacare tax… Accordingly, if you need to buff up on that, check out this post: Real estate investment and the net investment income tax.
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