Is a rental real estate activity considered a trade or business for tax purposes, or merely an investment? This question has entered the spotlight with the qualified business income (QBI) final regulations issued this year (T.D. 9847). The 20% QBI deduction under Sec. 199A introduced by the law known as the Tax Cuts and Jobs Act, P.L. 115-97, is available only for activities that qualify as a trade or business. Therefore, owners of rental activities that are not considered a trade or business may lose out on a significant tax deduction. This column examines the treatment of rental real estate activities under the final QBI regulations and additional guidance issued this year and suggests related planning opportunities.
The final QBI regulations offer three avenues for a rental real estate activity to be considered a trade or business eligible to generate QBI: (1) the rental activity qualifies as a Sec. 162 trade or business; (2) it rents to specific related parties; or (3) it satisfies the requirements of a proposed safe harbor.
SEC. 162 TRADE OR BUSINESS
To the dismay of practitioners and taxpayers alike, the regulations offered ambiguous rules to determine whether a rental real estate activity qualifies as a trade or business for QBI purposes. The final QBI regulations define a trade or business as a Sec. 162 trade or business other than performing services as an employee. Case law provides that a Sec. 162 trade or business entails a profit motive and requires considerable, regular, and continuous activity. A sporadic activity or hobby does not qualify for this purpose. The final QBI regulations offer several factors for analyzing whether a rental real estate activity is a Sec. 162 trade or business:
- The type of property rented (commercial versus residential);
- The number of properties rented;
- The owner's (or the owner's agents') day-to-day involvement;
- The types and significance of any ancillary services provided under the lease; and
- The terms of the lease (e.g., a net versus a traditional lease and a short-term versus a long-term lease).
The final regulations' preamble also notes that an activity treated as a Sec. 199A trade or business should also be treated consistently under other Code sections. For example, a tenancy in common renting real estate as a Sec. 199A trade or business should also be treated as an entity separate from its owners under Regs. Sec. 301.7701-1(a)(2). The preamble also says a factor in the appropriateness of treating a rental activity as a trade or business under Sec. 199A is whether the taxpayer complies with the requirements of Sec. 6041 (i.e., files required reporting forms, such as Form 1099-MISC, Miscellaneous Income). These factors encourage a case-by-case analysis. Rental activities with no active management likely do not qualify.
SPECIAL RULE FOR RENTING PROPERTY TO A RELATED PERSON
Fortunately, the final QBI regulations provide clearer guidance for certain related-party rentals. Under specific circumstances, a rental activity that rents to a related person is deemed a trade or business for QBI purposes. The activity must rent or license property to an individual or passthrough entity that is commonly controlled, which means the same person or group of persons owns at least 50% of the rental activity and the related trade or business. The related party cannot be a C corporation under this rule.
Note, however, that income derived from renting to a specified service trade or business (SSTB, which is not a qualified trade or business under Sec. 199A(d)(1)(A)) under this rule is treated as income from an SSTB and therefore may be partially or fully excluded from QBI, depending on the taxpayer's taxable income. An individual whose income exceeds a threshold amount (in 2019, $210,700 for single and head-of-household taxpayers; $421,400 for married taxpayers filing jointly; and $210,725 for married taxpayers filing separately) cannot take income from an SSTB into account in calculating the QBI deduction.
SSTBs include those in the fields of health; law; accounting; actuarial science; performing arts; consulting; athletics; financial services; brokerage services; those involving services of investing and investment management, trading, or dealing in securities, partnership interests, or commodities; and any business where the principal asset of the trade or business is the reputation or skill of one or more owners or employees.
As an example of this related-party rule, Partnership A exclusively rents office space to Partnership B, a law firm. Partnerships A and B have the same ownership. The net rental income from Partnership A is deemed QBI. However, the rental income is specified service income because Partnership B is an SSTB and the two partnerships are commonly owned.
PROPOSED SAFE HARBOR
The IRS issued Notice 2019-07 concurrently with the final QBI regulations. It provides proposed safe-harbor requirements for a rental real estate activity to qualify as a trade or business for QBI purposes. Note that the safe harbor does not need to be satisfied if the rental activity is otherwise considered a Sec. 162 trade or business or satisfies the related-party rental rule.
Practitioners and taxpayers who rely on the safe harbor are encouraged to carefully read its provisions, notably:
- Separate books and records must be maintained for the rental real estate activity;
- For tax years beginning prior to Jan. 1, 2023, at least 250 hours of rental services must be performed each year with respect to the rental activity by owners, employees, agents, and/or independent contractors;
- Contemporaneous records of services performed must be maintained for tax years beginning on or after Jan. 1, 2019;
- Real estate rented under a triple net lease in which the tenant or lessee pays for taxes, fees, insurance, and maintenance is not eligible for the safe harbor;
- Real estate activities are not considered a trade or business if real property is used as a residence as defined in Sec. 280A (i.e., it is used personally by an owner for a number of days that exceeds the greater of 14 days or 10% of the number of days during the year in which the property is rented at a fair rental); and
- A statement signed under penalties of perjury must be attached to the taxpayer's tax return that indicates the safe harbor has been satisfied.
The safe-harbor requirements may prove onerous but offer clearer criteria than the Sec. 162 trade-or-business provision.
PLANNING OPPORTUNITIES
Although classifying a rental activity as a trade or business that generates QBI may seem preferable, many rental activities generate losses for tax purposes due to depreciation, and thus may produce negative QBI, which is likely detrimental for tax purposes. Negative QBI offsets positive QBI from other sources and potentially carries over to subsequent years. Therefore, careful consideration should be made in classifying a rental activity that generates losses as a trade or business for QBI purposes.
Another planning consideration involves the related-party rental rule. Renting to a related C corporation does not satisfy this rule. Therefore, it may be preferential to elect S corporation status for the related C corporation to satisfy the related-party rule and generate QBI for the rental activity.
SEEKING CONSISTENCY
Applying the QBI deduction to rental activities is often left to the practitioner's judgment. The lack of a clear definition of a Sec. 162 trade or business requires practitioners to carefully analyze rental activities on a case-by-case basis. Practitioners should consider applying the special rule, which deems a related-party rental as a trade or business, and the proposed safe harbor. Hopefully, Treasury will issue more definitive guidance to promote consistent application of the QBI rental activity rules among taxpayers.
Alex K. Masciantonio, CPA, is a tax manager with Gunnip & Company LLP in Wilmington, Del. To comment on this article or to suggest an idea for another article, contact Paul Bonner, a JofA senior editor, at Paul.Bonner@aicpa-cima.com or 919-402-4434.