Section 199A Rental Property Deduction

By Jason Watson, CPA
Posted Tuesday, August 27, 2024

Section 199A deduction also known as the Qualified Business Income Deduction (QBID) arises from the Tax Cuts & Jobs Act of 2017. This is a significant tax break for small business owners and rental property owners but there are rules and limits of course.

Sidebar: It is a misnomer of sorts since it uses the term “pass-through” which is usually thought of in the context of S corporations and partnerships. To be certain, the Section 199A deduction is available from S Corps, partnerships, Schedule C, Schedule E and Schedule F activities.

Section 199, without the A, is the section covering the Domestic Production Activities Deduction. Section 199A is seemingly modeled after this (or at least a portion was ripped off by legislators) since the mathematics and reporting is similar between Section 199A and Section 199.

Section 199A Qualified Business Income deduction is a deduction from gross income on Line 13 on Page 1 of your individual tax return (Form 1040) for the 2023 tax year. Please recall that it is a deduction on your tax return since there are personal limitations. Therefore, two owners of the same business or rental property might have different results.

Calculating the Qualified Business Income Deduction

The basic deduction is 20% of net qualified business or rental income (profit) which is huge. If you make $200,000, the deduction is $40,000 times your marginal tax rate of 24% which equals $9,600 in your pocket. Here is the exact code-

(2) DETERMINATION OF DEDUCTIBLE AMOUNT FOR EACH TRADE OR BUSINESS. The amount determined under this paragraph with respect to any qualified trade or business is the lesser of-

(A) 20 percent of the taxpayer’s qualified business income with respect to the qualified trade or business, or

(B) the greater of-

(i) 50 percent of the W-2 wages with respect to the qualified trade or business, or

(ii) the sum of 25 percent of the W-2 wages with respect to the qualified trade or business, plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property.

Sounds easy enough, right? We don’t want to spend too much time on the calculus nuances, but rather move along to how rental properties play into all this.

Section 199A for Rental Properties

Rental properties are not automatically considered a trade or business (see definition below). Rather, the presumption is that they are passive and on the opposite end of the business spectrum. We discuss this in other sections of our book.

A business must have a profit motive; whether you actually earn a profit is irrelevant; it is your motivation and subsequent actions that dictate this determination. This is a critical distinction since most rental properties have a loss, especially in the early years with current market rent combined with depreciation and / or with relatively high mortgage interest, or both.

In addition to your profit motive, your participation in the business must be regular and continuous. Do not confuse this with material participation which has a series of bright line tests for short-term rental loophole or real estate professional status when viewed in the context of rental properties and real estate investments.

Armed with this knowledge, does your rental property qualify as a business and therefore for the Section 199A deduction?

Owning a rental property should generally qualify- profit motive, and regular and continuous participation. Easy! However, it is not a slam dunk. By using Alvary v. United States, 302 F.2d 790 (2d Cir. 1962) and Gilford v. Commissioner, 201 F.2d 735 (2d Cir. 1953), the IRS and others have come up with a mini facts and circumstances checklist-

• the type of rented property (commercial versus residential property)

• the number of rental properties (volume)

• taxpayer reliance on the activity for lifestyle or income

• time and effort spent on daily operations

• the types and significance of any ancillary services provided within the activity (think short-term rental, hunting lodge, tours, etc.)

• the terms of the lease (for example, a short-term versus long-term lease), and

• conformity to Section 199A’s preamble

What is the Section 199A preamble? Here is a snippet from page 16 the final regulations which eerily looks familiar to the list above-

In determining whether a rental real estate activity is a section 162 trade or business, relevant factors might include, but are not limited to (i) the type of rented property (commercial real property versus residential property), (ii) the number of properties rented, (iii) the owner’s or the owner’s agents day-to-day involvement, (iv) the types and significance of any ancillary services provided under the lease, and (v) the terms of the lease (for example, a net lease versus a traditional lease and a short-term lease versus a long-term lease).

That doesn’t really stand out as helpful or definitive either. The good news is that both the courts and the IRS have consistently found in favor of rental property owners and have allowed broad support for the profit motive including the regular and continuous requirements. Yay!

What is also a bit noteworthy is that the Section 199A proposed regulations summary released way back in August 2018 for rental activities had an example of a landowner who leased unimproved land to an airport for parking lots. People got hung up on the use of land this way, and leaped to the argument that all land rental activities rise to the level of a trade or business. The final regulations for Section 199A removed the land examples and stated that land rental activities might or might not be a trade or business depending on the facts and circumstances. Like Peyton Manning in his SNL United Way skit, “I’m not saying I’ve killed a snitch; I’m not saying I haven’t.”

The IRS and the Treasury Department recognized this conundrum, so they released IRS Notice 2019-7. In that Notice they defined a safe harbor for using the Section 199A deduction for rental properties-

Solely for the purposes of section 199A, a rental real estate enterprise will be treated as a trade or business if the following requirements are satisfied during the taxable year with respect to the rental real estate enterprise:

Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise;

For taxable years beginning prior to January 1, 2023, 250 or more hours of rental services are performed (as described in this revenue procedure) per year with respect to the rental enterprise; and

The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, regarding the following: (i) hours of all services performed; (ii) description of all services performed; (iii) dates on which such services were performed; and (iv) who performed the services. Such records are to be made available for inspection at the request of the IRS. The contemporaneous records requirement will not apply to taxable years beginning prior to January 1, 2019.

There are some other devils in the details such as not being able to combine commercial and residential rentals into a single enterprise, and there are lease type rules as well.

In our opinion, this safe harbor is anything but a safe harbor. A safe harbor is meant to cut down on the onerous nature of recordkeeping or provide bright lines to bolster the tax position. This is in favor of having a facts and circumstances based argument for your tax position. Read this Section 199A safe harbor again- separate books, a bunch of hours, and a log. Sounds like business as usual to demonstrate your regular and continuous involvement. The only silver lining we see is if you meet the safe harbor, then you are determined to have a profit motive.

Triple Net “NNN” Leases and Section 199A

We won’t spend too much time on this since there is no clean answer to this issue. Triple net leases or what most call NNN leases offload some of the expense to the tenants. This is very common in commercial real estate properties like office buildings and build-to-suit single user tenancy. Specifically, certain operating expenses, maintenance and property taxes are paid by the tenants on a pro-rata basis.

In turn, some argue then that this type of rental activity is not a business since expenses are being passed directly to the tenants. To make matters a bit worse, the rental property owner or property manager has very little incentive to reduce expenses since the tenants pay them directly. This is inconsistent with the profit motive of a business where you want to maximize revenue and minimize expenses.

Some resources suggest that NNN leases still rise to the level of IRC Section 162 and qualify for the Section 199A qualified business income deduction. How? Going back to the safe harbor, the profit motive is assumed should you meet the requirement in IRS Notice 2019-7. This is tricky to say the least.

Specified Service Trade or Business Inflection Point

This is a slight digression, but interesting, nonetheless. The IRS was concerned that a specified service trade or business (SSTB) could shift income that would normally not qualify for a Section 199A deduction into self-rental income that may qualify. This was part of the “crack and pack” strategy of splitting up an entity into SSTB and non-SSTB operations, thus being able to qualify for a Section 199A deduction on the non-SSTB operation (provided you hit those income limits that required the secondary SSTB test with the sliding scale of phaseout).

The proposed regulations 1.199A-5(c)(2) (and later finalized in the regulations) added provisions preventing this. So, if an accountant owns the firm and the office building in separate entities, the self-rental income becomes “tainted” and is considered SSTB income. This is because both entities have greater than 50% common control. No, you cannot have your spouse own the building and you own the SSTB business; attribution rules get in the way and state that you both own everything. Again, common control. Here is a blurb right from the regulations-

Example. Law Firm is a partnership that provides legal services to clients, owns its own office building and employs its own administrative staff. Law Firm divides into three partnerships. Partnership 1 performs legal services to clients. Partnership 2 owns the office building and rents the entire building to Partnership 1. Partnership 3 employs the administrative staff and through a contract with Partnership 1 provides administrative services to Partnership 1 in exchange for fees. All three of the partnerships are owned by the same people (the original owners of Law Firm). Because there is 50% or more common ownership of each of the three partnerships, Partnership 2 provides substantially all of its property to Partnership 1, and Partnership 3 provides substantially all of its services to Partnership 1, Partnerships 1, 2, and 3 will be treated as one SSTB under paragraph (a)(6) of this section.

This is unfortunate in our opinion. This same law firm leases office space from an unrelated party; the law firm might not qualify for the Section 199A deduction because of SSTB income limitations, sure, but the landlord might. Provided the rent charged in a self-rental situation is market rent, why can’t the law firm also be a landlord and enjoy a partial Section 199A deduction?