Under the Tax Cuts and Jobs Act, individuals, estates, and trusts may deduct 20% of their qualified business income (“QBI”) from sole proprietorships and pass-through entities. The basic framework of the IRC Sec. 199A deduction is a taxpayer deduction equal to the lesser of:
- 20% of the QBI of the taxpayer, or
- 20% of taxable ordinary income.
For purposes of this calculation, combined qualified business income includes the ordinary income from each “qualified trade or business.”
Qualified Trade or Business
A qualified trade or business is any trade or business other than (1) a specified service trade or business, or (2) the trade or business of performing services as an employee. As you will note, the deduction is allowed for a qualified trade or business. So what is the definition of a trade or business for this purpose and how does this apply in particular to real property rentals?
There is no universal definition of a trade or business and much of the discussion that follows is based on a large body of case law which can be summarized as follows…
- Determining whether an individual is carrying on a trade or business is based on the facts and circumstances as applicable to the taxpayer.
- To be engaged in a trade or business, an individual must be involved in an activity with continuity and regularity the primary purpose of which is to produce income or profit. The lead court case here is Commissioner v. Groetzinger, 480 US 23 (1987). Thus, sporadic activity, a hobby, or an amusement diversion does not qualify as a trade or business.
- Expenses incident to caring for one’s own investments, even if large scale so as to require office and staff, is not regarded as a trade or business.
- There is no requirement that the taxpayer be engaged in the selling of goods or services. The Groetzinger case cited above involved a professional gambler. Clearly, he was not engaged in selling goods or services nevertheless was held to constitute a trade or business.
Defining a Business Activity
Determining whether an activity rises to the level of a trade or business is particularly important in the context of rental real estate. Renting or managing rental property could be regarded either as a business activity or investment activity depending on the facts of the case. If it is a business activity, then it qualifies for the QBI deduction but if investment-related, then it does not qualify for the QBI deduction. And while the Tax Court has repeatedly held that the rental of even a single piece of real property can constitute a trade or business, the IRS has stated that ownership and management of real property in and of itself does not constitute a trade or business as a matter of law. So where does that leave us?
The question of whether there is a trade or business is one of fact and depends on the scope of ownership and management activities. Owning rental property qualifies as a business if it is engaged in to earn a profit and the activity is sufficiently systematic and continuous and there are a number of court cases in support of this proposition. There are some things that taxpayers can do to support their involvement in the trade or business.
- Apartment complexes, commercial rentals, residential rentals – document your involvement in terms of what you do to manage these properties—particularly if property managers are involved. Use of a real property agent is not necessarily a bar to the deduction because your supervision of the agent may be sufficient to qualify.
- Net leases – consider revising the terms of the lease to make the lessor responsible for handling and payment of maintenance, real property taxes, insurance, etc. There are adverse case law decisions in this area that the landlord may not meaningfully participate in the management of the property. If that would be the case, it would be difficult to argue that the property owner is regularly and continuously involved in a trade or business.
- Farmland rentals – may not qualify as QBI as the involvement of the landlord is not regular, systematic, and continuous.
- Vacant rental property – document your efforts to rent the property, what you are doing to attract tenants, why the property is vacant, and actions that you are taking rectify the situation.
Rules and Regulations
Recently issued regulations extend the definition of a trade for business in one circumstance. Solely for purposes of the QBI deduction, the rental of real property to a related trade or business is treated as a trade or business if the rental and operating trade or business are commonly controlled. As the Preamble to the proposed regulations points out, it is not uncommon that for good and sufficient non-tax reasons, that taxpayers may segregate the building rental from the operating business. This extension allows a taxpayer to aggregate their operating trades or businesses with the associated rental if the commonly controlled requirements are met.
Rental and operating trades or businesses can be aggregated under these rules:
- The same person or group of persons, directly or indirectly, owns 50 percent or more of each trade or business to be aggregated, meaning in the case of such trades or businesses owned by an S corporation, 50 percent or more of the issued and outstanding shares of the corporation, or, in the case of such trades or businesses owned by a partnership, 50 percent or more of the capital or profits in the partnership;
- The common ownership exists for a majority of the taxable year in which the items attributable to each trade or business to be aggregated are included in income;
- All of the items attributable to each trade or business to be aggregated are reported on returns with the same taxable year, not taking into account short taxable years;
- None of the trades or businesses to be aggregated is a specified service trade or business; and,
- The trades or businesses to be aggregated satisfy at least two of the following factors (so-called “economies of scale test”) based on all of the facts and circumstances:
- The trades or businesses provide products and services that are the same or customarily offered together.
- The trades or businesses share facilities or share significant centralized business elements, such as personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources.
- The trades or businesses are operated in coordination with, or reliance upon, one or more of the businesses in the aggregated group (for example, supply chain interdependencies).
As to real property, determining if a trade or business is involved can be daunting. Keep in mind that the substantial understatement of tax penalty is quite onerous if we get this wrong. Thus, documenting your involvement with the property is really important.
How DHJJ Can Help
If you have additional questions, contact DHJJ by calling 630-420-1360.