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.
General Rule: Regular, Continuous with a Profit Motive
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.
That One Special Case Situation
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.”
Valid Rental Deductions vs Section 162
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.
Trade or Business Status: What Counts
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.
Revenue Ruling 77-356
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…
Green v. Commissioner
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!)
Trade or Business Status: What Doesn’t Count
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.
Langford v Commissioner
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.)
Levinson v. Commissioner
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: The Commercial Fisherman
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.
Revenue Ruling 58-112: The Corporate Officer
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.”
Private Letter Ruling 9106004: Asthma Sufferer
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.
Summing Up the Section 199A Rental Property Deduction Examples
Just between you and me? I was initially a little frustrated that the IRS proposed and final regulations didn’t make it easier for us to identify what is and isn’t a real estate trade or business.
I wanted 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.
Or at least that’s what I thought until the IRS published its rental real estate safe harbor notice.
The Rental Real Estate Safe Harbor
On January 18, 2019, because lots of folks found the above rules and reasoning confusing, the Treasury and IRS issued the aforementioned safe harbor notice.
The safe harbor says that if a rental investor maintains separate books and records to reflect income and expenses for each rental real estate enterprise and then also maintains contemporaneous records to document that the investor and other workers spend 250 or more hours a year on the rental, that counts as good enough.
The IRS wrote strict rules about the contemporaneous time records. The records need to document the “hours of all services performed,” describe the services, supply the dates, and then identify who performed the services. (Services can be performed by the investor or someone else he or she hires like a repair person or property manager.)
Another wrinkle here? Only certain hours “count” toward the 250 hours requirement: advertising, verifying tenant information, rent collection, repairs and maintenance, daily operations stuff, property management, purchasing, and then supervision of employees and independent contractors.
Unfortunately, much other real estate work doesn’t count: arranging financing; procuring property; studying and reviewing financial statements, business planning, constructing improvements, and then hours spent traveling to and from properties.
Sizing Up the Rental Real Estate Safe Harbor
So, what to make of the safe harbor? Does it clear the fog? Maybe not.
Most tax CPAs I’ve talked with think the rental real estate safe harbor is problematic for small investors.
Well, when you look at the safe harbor rule and then ponder the way the Treasury and IRS hedge or hedged their language about the “Section 162 trade or business” standard in the final regulations and the tax form filing instructions, you get a distinct impression. That impression? It sure seems like having your real estate activity rise to the level of a “mere” Section 162 trade or business isn’t actually good enough.
To use quote a word from the final regulations, an investor’s activity needs to also be “considerable.” So this would be in addition to the investor showing regularity, continuity and a profit motive.
To quote another word from the draft IRS Publication 535 instructions, the IRS also wanted an investor’s activity to be “extensive.” So this would be in addition to the investor showing regularity, continuity and a profit motive. (In the final version of IRS 535 Publication, pointedly, the IRS removed the language requiring the investor’s activity to be “extensive.”)
In any case, in the end, small real estate investors who before the safe harbor notice seemed to qualify easily for Section 199A now don’t easily qualify.
Three Closing Comments
A handful of closing comments about all this stuff.
First, I personally think a taxpayer and her or his accountant bear some risk if the taxpayer falls short of the safe harbor’s requirements. In an audit situation, for example, an IRS agent may look at a failure to meet the safe harbor threshold and conclude the taxpayer doesn’t get the Section 199A deduction. (The IRS auditor may absolutely be wrong in their application of the regulations by taking this position. But having that argument simply may not be worth it.)
Second, losing the Section 199A on rental property isn’t all bad news. Not having to deal with Section 199A will simplify your tax returns. A taxpayer won’t have to calculate “qualified business income” or “negative qualified business income.” The resulting simplicity should mean you save time and money. Finally, you also shouldn’t have to worry about preparing and sending out 1099s to your vendors. (Only active trades or businesses need to do that.)
Third, we’ve got other “Section 199A real estate” related posts you might find useful. To learn how the Section 199A deduction works “just in general” for real estate investors, for example, check out our Real Estate Section 199A Deduction post. Further, if you’re interested in how the new loophole connects to like-kind exchanges, check out our Section 199A and Section 1031 post.
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