The Tax Cuts and Jobs Act (TCJA) tax reform added new tax code Section 199A, which created a 20 percent tax deduction possibility for you if your rental property (a) has profits and (b) can qualify as a trade or business.
As the law now stands, with rentals that achieve trade or business status, you win. Your business status rental property creates the following five possible tax benefits for you:
- Your rental property can create a Section 199A tax deduction of up to 20 percent of the rental property’s qualified business income (QBI).
- Your rental property receives tax-favored Section 1231 treatment, which (upon sale) delivers with a tax loss—an ordinary loss (the best kind of loss)—and with a tax-favored capital gain (the best kind of gain).
- Your rental property can create the home-office deduction if you meet the other home-office requirements of exclusive and regular use.
- Your rental-business status creates rental property deductions for the cost of your attendance at rental property meetings, seminars, and conventions.
- Your rental-business status enables Section 179 expensing for certain assets used in the business (special rules apply to the real property).
To obtain the benefits listed above, you must have a rental that qualifies as a trade or business.
New Safe Harbor Is Not the Answer
In Notice 2019-7, the IRS announced its rental property Section 199A tax deduction safe harbor that you can use to qualify your rentals as trades or businesses for purposes of Section 199A regardless of what they really are.
The automatic business treatment in this safe harbor likely does nothing for you. We say this because it’s likely that your rental qualifies as a trade or business without considering the safe harbor.
Another problem with the safe harbor is that it does not make your rentals trades or businesses for Section 1231, the home-office deduction, seminars, or the Section 179 deduction. Therefore, if you want to enjoy true business tax benefits from your rentals, you need to know whether they qualify, as a matter of law, as trades or as businesses.
IRS Publication 535
In its draft of IRS Publication 535, the IRS made this statement about Section 199A rental property:
The ownership and rental of real property doesn’t, as a matter of law, constitute a trade or business, and the issue is ultimately one of fact in which the scope of your activities in connection with the property must be so extensive as to give rise to the stature of a trade or business.
The “activities . . . must be so extensive” phrase in the above statement is clearly wrong as a matter of law, as you will see below. The IRS admitted that this phrase was an overreach when it removed the phrase from the final IRS Publication 535, which now contains the following:
The ownership and rental of real property may constitute a trade or business.
Four IRS Comments to Consider
In the preamble to the final Section 199A regulations, you find the following four comments:
- [S]ection 199A does not require that a taxpayer materially participate in a trade or business to qualify for the Section 199A deduction.
- Providing bright line rules on whether a rental real estate activity is a [S]ection 162 trade or business for purposes of Section 199A is beyond the scope of the final regulations.
- The Treasury Department and the IRS recognize the difficulties taxpayers and practitioners may have in determining whether a taxpayer’s rental real estate activity is sufficiently regular, continuous, and considerable
[we deal with this unjustified word below] for the activity to constitute a [S]ection 162 trade or business.
Accordingly, Notice 2019-07, 2019-9 IRB, released concurrently with these final regulations, provides notice of a proposed revenue procedure detailing a proposed safe harbor under which a rental real estate enterprise may be treated as a trade or business solely for purposes of [S]ection 199A.
- A rental real estate enterprise that satisfies the proposed safe harbor may be treated as a trade or business solely for purposes of [S]ection 199A, and such satisfaction does not necessarily determine whether the rental real estate activity is a [S]ection 162 trade or business.
Harbinger of Where the IRS Is Going
As shown in comment 3 above, the IRS uses the words “sufficiently regular, continuous, and considerable for the activity to constitute a [S]ection 162 trade or business” in justifying its issuance of Notice 2019-7. This is an overreach, as we explain below.
Note how the words above almost mirror the “must be so extensive” comment that the IRS removed from Publication 535.
The Supreme Court in Groetzinger stated:
We accept the fact that to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity[,] and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit. A sporadic activity, a hobby, or an amusement diversion does not qualify.
In the preamble to its final Section 199A regulations, the IRS adds “considerable” (page 2954) to “regular” and “continuous,” with its reference to Groetzinger. The word “considerable” does not appear in the Groetzinger case.
You can see that the IRS would like the higher standard of “so extensive” or “considerable” to apply to rentals. It does not, as you will see below in the description of Hazard, which is the precedent for rental cases other than those in the U.S. Court of Appeals for the Second Circuit.
Leland Hazard owned residential property in Kansas City, Mo. The property was purchased in 1930 and was occupied by Hazard as his residence from 1930 until July 1939, at which time he moved to Pittsburgh, PA.
In 1940, Hazard listed the Kansas City property with real estate agents for sale or rent. The property was rented in early 1940 and continued to be rented until it was sold on November 1, 1943.
Hazard recognized a net loss of $6,844.22 ($99,428.42 in today’s dollars) from the sale of the property and claimed that the loss was an ordinary loss.
The IRS argued that the loss was a long-term capital loss because the Kansas City property was not used in a trade or business. In other words, the IRS argued that Hazard had held the property simply for investment.
The tax court, relying on Fackler, held that the taxpayer recognized an ordinary loss because a single piece of real property that is rented constitutes property used in a trade or business whether or not the taxpayer is engaged in any other trade or business.
The IRS acquiesced in the Hazard decision and has consistently followed that decision since 1946.
For more on rental properties as a business, see Are Your Rental Properties a Business? If So, You Win.
The Second Circuit appeals court broke from the trivial rental property activity standard found in Hazard when it ruled against Grier, who inherited a single-family home and rented it for 14 years to the same tenant, but could not show regular and continuous management or other activity.
Under the Golsen doctrine, the tax court applies the Grier ruling to taxpayers who reside in the Second Circuit (Connecticut, New York, or Vermont), and with this residency, you need to show some involvement with your rentals.
In Murtaugh, the IRS stressed to the court that this case was appealable to the Second Circuit and that the court must therefore follow the law of the Second Circuit and not Hazard.
The IRS and Murtaugh agreed that Murtaugh had a $59,700 loss deduction but disagreed as to its treatment as an ordinary or a capital loss. If Murtaugh could prove that his timeshares were used in a trade or business, he would win an ordinary loss deduction; if not, he had a capital loss.
In making its decision, the court noted that under Groetzinger, Murtaugh had to be involved in the timeshares with continuity and regularity; furthermore, his purpose for the timeshares’ investment had to be for income or profit.
The court decided for Murtaugh on the basis of his two-day annual visits to the property during the offseason (not a vacation trip) and of the attribution to Murtaugh of the timeshare operators’ management activities, which included handling rental contracts, promotional advertising, housekeeping, replenishment of inventory, and guest registration.
If you live outside Connecticut, New York, and Vermont, your precedent for what makes your rental a trade or business is the Hazard case. It’s hard to think that your rental activities cannot reach the single-family rental property standard set forth in Hazard.
And establishing trade or business status under Hazard is certainly easier and less complex than establishing rental property business status under the IRS safe harbor laid out in Notice 2019-7.
Even in the Second Circuit, a showing that you are involved in the rental and management of the property should enable you to claim that your rental is a trade or business. Note how Murtaugh won his case based not on his involvement but on the involvement of the timeshare management company.
All this means that the IRS’s “so extensive” and “considerable” guidelines are not on point with what precedent says is a rental property trade or business, so you likely don’t have any great reason to subject yourself to the complexities of the safe harbor.
Please contact us if you have questions about Section 199A qualification and other real estate tax questions.