Tax Reform and Your Business: Landlords and Rental Trade or Business Determinations (article)
When one thinks of a landlord, the image that typically comes to mind is someone who owns and rents several residential rental properties or buildings that house small businesses. Landlords encompass a large swath of the real estate sector that ranges from large apartment complexes to timeshares and land leases. Landlords stand to benefit from a new 20 percent deduction against their Qualified Business Income (QBI) from real estate rentals under the tax reform law commonly known as the Tax Cuts and Jobs Act (TCJA). The rental activities of landlords must rise to the level of a “trade or business” to qualify for the QBI deduction. The term “trade or business” is not defined in the Internal Revenue Code or Regulations. As a result, landlords and their tax advisors have wrestled with this determination for years, and the QBI deduction now makes it more important than ever.
Bringing the Trade or Business Determination into Play
Earlier versions of the TCJA left the rental trade or business determination moot, but a last minute change to the TCJA provided a big boost to landlords. This change was to the wage limit for the QBI deduction. Prior drafts of the legislation limited the deduction to the smaller of 20 percent of QBI or 50 percent of wages allocable to QBI. The last minute addition changed the wage limit to an amount that is the greater of:
- 50 percent of wages allocable to QBI, or
- 25 percent of wages allocable to QBI plus 2.5 percent of the unadjusted basis of tangible property (including all real estate except land)
This change may have unlocked the benefit of the QBI deduction for many landlords who, due to the nature of their business, may not have had enough wages to take advantage of the deduction. The change does not automatically qualify landlords for the QBI deduction, however, because they still have to pass the threshold of establishing that their rental operations qualify as a trade or business.
Rental Trade or Business vs. Other Rental Arrangements
The question of when a rental activity rises to the level of a trade or business is one that has befuddled taxpayers, accountants, and the courts for a long time. A trade or business for tax purposes stands in contrast to an activity engaged in by the taxpayer for the production of income. Stated differently, a business activity is something more than a mere investment.
Either form of rental activities is reported by individual taxpayers on Schedule E. Rental activities that are a trade or business of a taxpayer are subject to passive activity loss limitations, whereas deductions for rental properties held for the production of income are allowed only to the extent of the gross income from such activities.
Trade or Business Judicial Standards
Location, location, location—it’s a real estate agent’s mantra, but it is also an important factor in the question of whether a landlord’s activity will be classified as a trade or business. The Supreme Court held in Commissioner v. Groetzinger that an activity arises to the level of a trade or business if it is engaged in continuously and regularly for the purpose of making a profit. However, this is a very broad standard, and the facts did not involve rental real estate. This left various lower courts to the difficult task of interpreting and applying this test.
The courts have taken different approaches and arrived at different conclusions for rental trade or business determinations, even where the facts were substantially similar. For instance, the Tax Court and the Seventh Circuit Court of Appeals will generally find that the rental of a single-family residence is a trade or business, while a landlord in the Second Circuit could find that the court disagrees on similar facts. The level of the landlord’s involvement was relevant in each of these cases. The courts tend to find rentals of commercial properties as more indicative of a trade or business per se, due to their inherent demands on a landlord’s involvement. Nevertheless, the favorable decisions involving a single family residence required only a minimal amount of involvement (holding the property for rent and attempting to find tenants). The Tax Court, however, requires more involvement when the property is a residence that the landlord previously occupied.
The Net Investment Income Tax Regulations
There is some IRS guidance that might be helpful with a landlord’s rental trade or business determination. Landlords are subject to the 3.8 percent Net Investment Income Tax (NIIT) on rental trade or business activities that are passive in nature, or on rental properties held for the production of income (i.e., not held in a trade or business). Landlords can avoid the NIIT by proving that their rental activities are not covered by either of these two categories, and instead are trade or business activities that are non-passive in nature.
The NIIT law does not define trade or business, but refers instead to another Code section that also lacks a definition. The IRS published regulations pertaining to the rental trade or business determination for NIIT purposes, but this guidance presently is limited to the NIIT. Even if one makes a leap to interpret the NIIT regulations as analogous for QBI trade or business purposes, the NIIT regulations are of limited help. These regulations cryptically refer to facts and circumstances to make a trade or business determination. Examples of relevant factors include the type and number of rented properties, the landlord’s personal involvement and that of his agent, and whether the rental is a “triple net lease.” The regulations further provide that the rental of a single property does not rise to the level of a trade or business in every case, and provide one example where it does not. The tax community roundly criticized this example as it ignores trade or business standards established by three prior Tax Court decisions, which generally require only a small amount of involvement to establish a trade or business (the example essentially requires more than a small amount of involvement).
Triple Net Lease Arrangements
The IRS and the various courts provide one clear example of when a landlord is not engaged in a trade or business. This involves a situation commonly called a triple net lease. A triple net lease requires the tenant to pay all taxes, insurance, and maintenance. This generally removes so much responsibility for property management from the landlord that the landlord no longer continuously and regularly engages in the activity of renting the property. Landlords seeking trade or business treatment of rental activities will need significant involvement in triple net lease arrangements.
Engaging in a Rental Trade or Business
The courts and the IRS consistently focus on significant services provided to the tenant as part of a rental trade or business determination. In the case of the triple net lease, it is clear that the landlord is not providing significant services. Alternatively, a landlord of a fully furnished apartment that performs all of the necessary maintenance services is clearly performing a significant amount of services. In analyzing cases that fall between these two extremes, it is important to note that there is no bright-line rule. Each set of circumstances is judged independently. In many cases, the courts found that a landlord’s involvement actually can be performed by an agent or management company.
The nature of the property and the number of properties held by the taxpayer are also important factors. For example, an owner of a shopping mall that is leased to tenants will generally be found to be in a trade or business as the nature of malls require that the landlord provide significant services directly or through agents and employees. The owner of many single family rentals may also be engaged in a rental trade or business, but if the purpose for holding multiple properties as a group is primarily for investment, the trade or business argument will be impeded.
A careful and detailed analysis of the facts is necessary when determining whether a rental activity is a trade or business. However, this analysis can provide significant benefits as the prize for achieving trade or business status is avoidance of the 3.8 percent NIIT (assuming the landlord is also non-passive) and potential eligibility for the 20 percent QBI deduction. Taken together, this could result in a decrease in the taxpayer’s effective tax rate from 40.8 percent to 29.6 percent. To learn more about these tax benefits and to receive assistance in determining whether your rental activity may be considered a trade or business, please contact your local CBIZ Tax Professional.
Copyright © 2018, CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without the express written consent of CBIZ. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.
CBIZ MHM is the brand name for CBIZ MHM, LLC, a national professional services company providing tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly-traded and privately-held companies. CBIZ MHM, LLC is a fully owned subsidiary of CBIZ, Inc. (NYSE: CBZ).