Regrettably, the most misunderstood issue for preparing taxes for 2018 could be the most significant - the issue of when a rental activity is a trade or business qualified for the new Sec 199A deduction. The final regulation (§1.199A-1(b)(14)) defines a trade or business as being the same as trade or business under Code Sec. 162.
Whether a taxpayer is engaged in a trade or business under section 162 requires an examination of all the facts and circumstances. (Higgins v. Commissioner, 312 U.S. 212 (1941))
The courts have laid out two conditions necessary for an activity to be a trade or business. The first requires the taxpayer to carry on the activity with the intent of making a profit. (See Ferrell v. Commissioner, 90 T.C. 1154 (1988) and Dreicer v. Commissioner, 78 T.C. 642, 645 (1982), aff'd without opinion 702 F.2d 1205 (D.C. Cir. 1983)) The second requires the scope and level of taxpayer activity to be considerable, regular, and continuous. (See Groetzinger v. Commissioner (U.S. Supreme Court) 480 U.S. 23, at 32, 35 (1987)).
Applying these two conditions to Rental Real Estate. The Treasury/IRS reg writers received a number of requests for “bright line rules” to help taxpayers and tax preparers determine whether a rental real estate activity is a trade or business. In response Treasury/IRS issued Notice 2019-07 to address this issue.
Notice 2019-07 and the 250-hr Safe Harbor – Notice 2019-07 merely provides a safe harbor that, if all required conditions are met, the IRS agrees to treat the rental real estate activity as a trade or business. It does not provide a definition of a trade or business. Failure to satisfy the requirements of the safe harbor (i.e., the 250 hours test) does not preclude a taxpayer from otherwise establishing that a rental real estate enterprise is a trade or business for purposes of Sec 199A. Even the final Sec 199A regulations, under Comments and Explanation of Revisions (Section 3, page 12) articulates that whether an activity is a trade or business is determined by Sec 162.
Preparer Trap and Pitfall – To quote a close friend of mine, “dealing with rentals and Sec 199A for 2018 is like sitting in the front seat between Bonnie and Clyde.” Making the ultimate decision that a rental activity is a trade or business solely on the basis of the Notice 2019-07 safe harbor can lead to big problems. The 199A deduction takes into account both positive (net profit) and negative (net loss) qualified business income (QBI) and negative QBI reduces the positive QBI from other activities, and in doing so, reduces the 199A deduction. Thus, if a loss activity qualifies under Sec. 162 and it is not treated as a trade or business because it did not meet the 250-hour safe harbor, that does not preclude the IRS from determining it is a trade or business based upon Sec 162. The best way to look at the safe harbor is the IRS will not challenge your position that the rental IS a trade or business, BUT it is not a safe harbor that a rental is NOT a trade or business.
Citations – Here are court cases related to the issue of rental real estate as a trade or business (note the liberal leaning toward trade of business, except for limited exceptions and cases in the 2nd Circuit):
1. Facts and circumstances of each case must be examined – Higgins Sup Ct 312 U.S. at 217.
2. Two definitional requirements:
a. Profit motive;
b. The second is in relation to the scope of the activities, which must be “beyond the scope of mere ownership of property” and must be considerable, regular, and continuous activity. See generally Commissioner v. Groetzinger, 480 U.S. 23 (1987) for “regular and continuous” requirements. (See also GCM 38779 which says only a “relatively small amount of activity” is required;
i. “Considerable” rather than minimal
ii. Regular as opposed to irregular
iii. Continuous – not “sporadic” - “The property was continuously rented.” No deviation throughout ownership of its “planned use”. Good v. Commissioner, 16 T.C. 906 (4/26/51)
3. Activities that are considered: Even though an agent or manager “negotiated or renewed leases, arranged for repairs, collected rents, paid taxes and assessments, and remitted net proceeds to landlord, local agent paid principal and interest on the mortgages, insurance premiums, and taxes. Agent retained commissions and amounts to be applied on landlord’s income taxes and the remainder was sent to landlord. These activities were beyond the scope of mere ownership of property and the receipt of income”. They were considerable, continuous, and regular. De Amodio v. Commissioner, 34 T.C. 894
To the same conclusion: executing leases and renting the properties, collecting the rents, keeping books of account, supervising any necessary repairs to the properties, paying taxes and mortgage interest, insuring the properties, executing an option to purchase property, and executing the sale of the property. In addition, the agent conducted a regular correspondence with the landlord; he submitted monthly reports; and he advised him of prospective and advantageous sales or purchases of property.
These activities are beyond the scope of mere ownership of real property, or the receipt of income from real property. The activities were considerable, continuous, and regular.
4. One rental with minimal activity was a trade or business – Hazard v Comm.’r, 7 T.C. 372 (1946), LaGreide, 23 T.C. 508 -taxpayer inherited a single residence which she then rented out. Tax Court found it to be a trade or business. "It is clear from the facts that the real estate was devoted to rental purposes, and we repeatedly held that such use constitutes use of the property in trade or business, regardless of whether or not it is the only property so used.”
5. Other cases with level of activity that definitely should put you over the top even in the 2nd circuit mentioned in Grier was Pinchot v. C. I. R., 2 Cir., 1940, 113 2d 718 (eleven commercial buildings in New York), Gilford v. C. I. R., 2 Cir., 1953, 201 F.2d 735, (eight buildings in New York), Fackler v. C. I. R., 6 Cir., 1943, 133 F.2d 509 (a six-story commercial building), Rogers v. U.S., D.C.Conn.1946, 69 F. Supp. 8 (sixty-one properties).
6. 25% interest in two timeshare units rented were a trade or business - James B. and Joan E. Murtaugh v. Commissioner [74TCM75][1997-319] Timeshare units in a resort lodging facility were trade or business even though they lost money for two years and then were sold.
7. But a triple net lease does not qualify since it is specifically not allowed per Section 3.05 of Notice 2019-07. The Rev Proc defines a triple net lease as one where a lease agreement requires the tenant or lessee to pay taxes, fees, and insurance, and to be responsible for maintenance.a. Land leased where the landlord pays taxes, insurance, fees and is responsible for and does repairs is arguably a trade or business.
b. Land leased where the landlord pays taxes, insurance, fees and is responsible for, but the lessee does, repairs...not so sure.
c. Land leased where the landlord pays taxes, insurance, fees and lessee/tenant is responsible for and does repairs…doubtful.
8. Other situations that may or may not qualify as trade or business:a. Not rented at fair rental value – It is not uncommon for landlords to rent a property to a relative or friend at less than the fair rental value. Therefore the property owner is not engaging in the activity for income or profit.
b. A vacation home rented and used personally will generally not qualify because the personal use violates the continuity and regularity of the activity.
Thus, given this case law history, virtually all rental real estate activities will meet the definition of a trade or business and their profit or loss should be included in QBI.