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Section 199A Rental Property Deduction
By Jason Watson, CPA
Posted Wednesday, November 1, 2023
Defining a trade or business is easy for the most part, however certain activities are murky and one of them is rental properties. On one hand an argument that rental property income is already tax advantaged can be made since it is not subject to self-employment taxes (Social Security and Medicare). However, if it were subject to SE tax, people would simply create management entities, elect S Corp status, ding the rental a management fee and achieve a Section 199A deduction that way. This is perhaps one reason the IRS isn’t raising a big stink on rental properties.
Commenters in reference to August 2018’s proposed Section 199A regulations asked for a regulatory definition, a bright-line test, a factor-based test or a safe harbor. Something that can be pointed to on a chart. The Treasury declined to do so and relied on the Higgins and Groetzinger tax court cases to help shape the definition. This is good; while we nerdy accountants want 1 + 1 to equal 2, this squishy definition allows for wiggle room.
In Higgins v. Commissioner, 312 U.S. 212 (1941), the Supreme Court noted that determining whether a trade or business exists is a factual determination. Because there is no statutory or regulatory definition of a Section 162 trade or business, courts have established elements to determine the existence of a trade or business.
- One, in relation to profit motive, is said to require the taxpayer to enter into and carry on the activity with a good faith intention to make a profit or with the belief that a profit can be made from the activity.
- Second, in relation to the scope of the activities and is said to require considerable, regular, and continuous activity.
Along came Commissioner v. Groetzinger, 480 U.S. 23 (107 S.Ct. 980, 94 L.Ed.2d 25) where the U.S. Supreme Court in 1987 stated, “we do not overrule or cut back on the Court’s holding in Higgins when we conclude that if one’s gambling activity is pursued full time, in good faith, and with regularity, to the production of income for a livelihood, and is not a mere hobby, it is a trade or business within the statutes with which we are here concerned.” This is re-affirming a 1941 holding in 1987; no narrowing; no re-shaping.
Review those two elements again; fairly straightforward, right? Intend to make a profit, and perform your activities regularly and continuously. Got it… easy!
In terms of rental activities rising to the level of a trade or business, the summary of the Section 199A final regulations read-
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). (Final Regs, page 16)
The operable word is “might.” Read it again… “relevant factors might include…” Might and must are wholly different just like may and shall. Certainly using the relevant factors including the wording as you pitch your “Higgins” argument will bolster your position. Having said this, the IRS released Notice 2017-9 which creates a rental safe harbor; the massive takeaway is this- your rental activities may rise to the level of a trade or business without complying with the IRS Notice per the preamble.
What is also a bit noteworthy is that the Section 199A proposed regulations summary released 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.”
Don’t read too much into the words “earn a profit.” This does not mean it must earn a profit… but your intentions for conducting the activity is to earn a profit. Whether you earn a profit or not does not necessarily alter your intentions. Make sense? In other words, “I wanna earn a profit. I’m doing all the right things to make a buck, yo, but right now times are tight and this depreciation thing is killing me.”
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 taking 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.
Self-rentals pose an interesting situation as we alluded to in a previous section. For example, you own some equipment personally and lease it back to your business. Provided the arrangement is at market rates, we believe this still qualifies for the Section 199A deduction as a rental business for two reasons. First, how is this any different than an external business who leases the equipment to unrelated parties? That ordinary income would qualify. Second, you are moving dollars from your right pocket to your left pocket, and absent of the SSTB designation, you are just swapping Section 199A dollars.
Caution: the self-rental consideration has not been challenged in a tax court; there is a lot of risk since your Section 199A deduction on a self-rental is predicated upon being able to demonstrate that it rises to the level of a trade or business.
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 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. And 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 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? We want to say Yes, but the IRS says No. We believe this will be challenged in some fashion since it appears on its face to be discriminatory, and provided the self-rental is at market rates it appears to treat two rental operations differently depending on the relationship between landlord and tenant.
For non-specified service trade or business situations, the big takeaway is make sure this transaction has all the appearances of an arms-length transaction, fair dealings (versus self-serving), fair market pricing, etc.
So, as of right now, rental property owners are able to calculate and use the Section 199A qualified business income deduction if they meet the requirements in IRS Notice 2019-7. Also, be cautious when considering the self-rental situation. Rental property ownership is also where depreciable assets come into play for determining the Section 199A limitations. No, you do not need to pay a W-2 salary from your rental property to enjoy the qualified business income deduction since your depreciable assets should trump this limitation.
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