TCJA Tax Strategies 1: The Qualified Business Income Deduction and Rental Real Estate
In case you haven’t been paying attention to last year’s tax reform, now is the time to take note. The Tax Cuts and Jobs Act (TCJA) passed in December of 2017 introduced significant changes to the US tax system with much of the benefit flowing to businesses and those with certain types of investment exposures. Understanding how to apply the new tax law to any taxpayer’s specific situation is essential, but IRS regulations and practical guidance on the law are minimal so far. DukhonTax is closely following developments related to the TCJA, forecasting strategies, and staying up to date on authoritative guidance as it comes out. This post is the first of our TCJA Tax Strategies blog series that we will share throughout the year to help you plan for tax efficient decision making in 2018.
Section 199A and Rental Real Estate
A common investment strategy for many of our clients is investment in a rental real estate property. Residential leasing is more common but some clients hold commercial real estate exposures. We are seeing a constant increase in AirBnB and similar short-term rental exposures. A common question is if the Section 199A deduction for Qualified Business Income can be taken on income from a rental real estate property. We think yes but the IRS has not yet issued clear guidance, and current law must be carefully navigated.
What is the Qualified Business Income Deduction?
First, a quick refresher on the QBI deduction in general:
The deduction is 20% of “qualified business income (QBI)” from a partnership, S corporation, or sole proprietorship, defined as the net amount of items of income, gain, deduction, and loss with respect to the trade or business. The business must be conducted within the U.S. to qualify, and specified investment-related items are not included, e.g., capital gains or losses, dividends, and interest income (unless the interest is properly allocable to the business). The trade or business of being an employee does not qualify. Also, QBI does not include reasonable compensation received from an S corporation, or a guaranteed payment received from a partnership for services provided to a partnership’s business.
The deduction is taken “below the line,” i.e., it reduces taxable income but not adjusted gross income. But it is available regardless of whether a taxpayer itemizes deductions or takes the standard deduction. In general, the deduction cannot exceed 20% of the excess of taxable income over net capital gain. If QBI is less than zero it is treated as a loss from a qualified business in the following year.
Rules are in place to deter high-income taxpayers from attempting to convert wages or other compensation for personal services into income eligible for the deduction.
For taxpayers with taxable income above $157,500 ($315,000 for joint filers), an exclusion from QBI of income from “specified service” trades or businesses is phased in. These are trades or businesses involving the performance of services in the fields of health, law, consulting, athletics, financial or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners.
Additionally, for taxpayers with taxable income more than the above thresholds, a limitation on the amount of the deduction is phased in based either on wages paid or wages paid plus a capital element.
Here’s how it works:
- If your taxable income is at least $50,000 above the threshold, i.e., $207,500 ($157,500 + $50,000),
- your deduction for QBI cannot exceed the greater of
- (1) 50% of taxpayer’s allocable share of the W-2 wages paid with respect to the qualified trade or business, or
- (2) the sum of 25% of such wages plus 2.5% of the unadjusted basis immediately after acquisition of tangible depreciable property used in the business (including real estate).
- your deduction for QBI cannot exceed the greater of
Other limitations may apply in certain circumstances, e.g., for taxpayers with qualified cooperative dividends, qualified real estate investment trust (REIT) dividends, or income from publicly traded partnerships.
Is Rental Real Estate a Qualified Business?
The QBI deduction is available for the “qualified business income” of a “qualified business.” The question then: Does the renting out of property for income rise to the level of a qualified business?
According to IRC § 199A(b)(2)(A), a taxpayer must be engaged in a “qualified trade or business” to claim the pass-through or sole-proprietor deduction. The term “trade or business” is no small thing within the tax law and is the terminology used in IRC 162 which governs deductions for business expenses. However, the term is not defined in the code and the meaning has only been developed in case law. Some key aspects of an activity meeting this standard is that a taxpayer must be involved in the activity “with continuity and regularity” and the primary purpose must be for income or profit. Showing what is called a profit motive is easier as the goal of most businesses is to earn profits unless the business is specifically designed as a non-profit or hybrid entity. The definition of “continuity and regularity” may be more open to interpretation as evidenced by case law. To consider the application of the QBI deduction on rental real estate activities, section 199A must be considered on the basis of pre-existing definitions of activities within the code and regulations.
Per IRC 199A every trade or business is a qualified business other than
- The trade or business of performing services as an employee and
- A specified service trade or business (see a future post in this series for more info on this one)
However, since what constitutes a trade or business is not defined in statute or regulations then it is a factual determination made on a case by case basis. While IRC 199A does reference a “qualified trade or business” – it similarly does not define it. It is not clear if 199A is referencing the standard under IRC 162, but it likely is as that is the commonly referenced code section of guidance and case law in “trade or business” expense disputes. Also, attention should be paid to IRC 1411 and related regulations which:
- Define “trade or business” (within those regulations) as a “trade or business within the meaning of Section 162”
- The reference to IRC 162 “incorporates case law and administrative guidance applicable to IRC 162”
Referencing TD 9644 (Treasury Decision 9644, 12/2/2013) which provides guidance related to IRC 1411:
“Within the scope of a section 162 determination regarding a rental activity, key factual elements that may be relevant include, but are not limited to,
- the type of property (commercial real property versus a residential condominium versus personal property),
- the number of properties rented,
- the day-to-day involvement of the owner or its agent, and
- the type of rental (for example, a net lease versus a traditional lease, short-term versus long-term lease).
Therefore, due to the large number of factual combinations that exist in determining whether a rental activity rises to the level of a section 162 trade or business, bright-line definitions are impractical and would be imprecise. The same is true wherever the section 162 trade or business standard is used and is not unique to section 1411. The Treasury Department and the IRS decline to provide guidance on the meaning of trade or business solely within the context of section 1411. However, the Treasury Department and the IRS have modified Example 1 in § 1.1411-5(b)(3) to explicitly state that the rental property in question is not a trade or business under applicable section 162 standards.”
The reference to Example 1 – which specifically states an activity that is not a trade or business:
A, an unmarried individual, rents a commercial building to B for $50,000 in Year 1. A is not involved in the activity of the commercial building on a regular and continuous basis, therefore, A’s rental activity does not involve the conduct of a trade or business, and under section 469(c)(2), A’s rental activity is a passive activity.
A rental activity is generally considered to be a passive activity and not a trade or business (IRC 469(c)(2)). Remember, there is an exception to this rule for Real Estate Professionals – those are individuals who are engaged in the business of real estate and can meet certain thresholds and requirements – that can allow treatment of rental activities as nonpassive. For more guidance on qualifying as a Real Estate Professional please contact our office.
There are some exceptions that can qualify a rental property as a trade or business:
- Average Period of Customer Use is Seven Days or Less (A big planning opportunity here for customers with AirBnB and short-term rentals)
- Average rental period is 30 Days or Less and Significant Personal Services are Provided
- Taxpayer Provides Extraordinary Personal Services in Connection With Property Rental
- Rental Is Incidental to a Nonrental Activity
- Tangible Property Is Made Available for Nonexclusive Use by Various Customers
- Partner, S Shareholder or Joint Venturer Provides Tangible Property to Entity for Use in Nonrental Activity
At this time, the plain reading of the term “trade or business” and regulations related to rental activities means that only very specific rental activities would qualify or meet the test. The expectation is that future regulations around 199A will provide safe harbors or other provisions for rental real estate activities that do not rise to the level of a trade or business to qualify for the deduction. An often referenced provision of the QBI deduction and 199A is that a non-corporate taxpayer is permitted a deduction of 20% of any qualified dividends from a real estate investment trust or REIT. So in this case, the QBI is applicable for such types of income. REITs specifically hold passive assets that would not rise to the level of a trade or business in the hands of, say, an individual taxpayer. Logically, since the QBI is allowed on such income it should be allowed on income from rental real estate activities.
While some credence must be had in the guidance around IRC 162 and 1411 as they relate to rental real estate activities, the legislative intent and structuring of Code Section 199A likely did not intend to exclude rental real estate holders. We are awaiting further guidance as it comes out and drafting plans for our clients that consider both options.
- The 20% qualified business income deduction (IRC 199A) is allowed on the income of a qualified trade or business.
- Rental activities do not generally rise to the standard of a trade or business but exceptions are available and our firm can recommend strategies for actively operated properties and specific types of rental exposures.
- Future IRC 199A regulations related to the qualified business income deduction should provide guidance for rental real estate activities or other safe harbor measures to allow operators of rental real estate to take the Qualified Business Income deduction.
- Combining operations of rental real estate with other activities or grouping operations combined with utilization of pass-through and corporate entities is an overall planning recommendation for real estate operations after the TCJA. Besides the QBI deduction, other opportunities exist.
- Our expectation is that our clients with rental real estate properties will be able to take the deduction once authoritative guidance is issued. We await further information from the IRS and can work with you right now to discuss planning options specific to your situation.
For further questions on the utilization of this law or other aspects of the Tax Cuts and Jobs Act please contact Dukhon Tax for tax consultation, planning, guidance, and preparation.
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