The 20% Business Deduction: Does Rental Real Estate (RRE) qualify?
As most taxpayers now know, the new tax laws signed into effect for 2018 have given us a special 20% business deduction (referred to as the Section 199A deduction).
The calculations behind the deduction are very simple for those making less than $157,500 ($315,000 if filing joint):
- Wages & Salary from Employment – DOES NOT QUALIFY
- Schedule C – Net Income from the Business
- Schedule E – Will Depend (More on that Later)
- S-Corporation – Amount of Ordinary Income On K-1 (May Include Rental Real Estate As Well, More on that later)
- Partnership – Amount of Ordinary Income On K-1 (May Include Rental Real Estate As Well, More on that later)
- Joe works a normal 9-5 job and receives a $50,000 gross salary. None of this income will qualify for the business deduction because he is strictly an employee.
- Jerry married and is a real estate agent and his total taxable income is $200,000. His Schedule C income as an agent is $150,000. He will receive a special business deduction of $30,000 this year (20% of his $150,000 Schedule C business income).
- John is a real estate flipper making $200,000 per year. He is married. He runs his flipping business through an S-Corporation. He receives a $50,000 gross salary, leaving $150,000 as the company’s leftover business income. He will receive a special business deduction of $30,000 this year (20% of his $150,000 amount left over on his K-1).
- Jeff purchases real estate, remodels them, rents them out, and sells after a year for capital gains. The capital gains will never qualify for the 20% deduction (as the deduction only applies to ordinary income). Jeff’s rental real estate may qualify, depending on several factors. One of which is his risk tolerance.
In what situations does RRE qualify for the 20% Business Deduction?
SIMPLE YET COMPLEX ANSWER: IT DEPENDS
Basically any trade or business outside of a list of certain service industries (and even those service industries still qualify just. In writing the original law, Congress defined the businesses that qualify for the 20% deduction as as long as taxable income is below the limits mentioned earlier in the article).
So, the main question is….”Does RRE fall under the definition of any trade or business?”
In an audit, the IRS generally starts by answering that question as *no*, and will push the burden onto the taxpayer to prove otherwise. Even in cases where a good argument is put forth, the IRS will often still reject the taxpayer’s claim and require they appeal to the next level of review.
In appeals, these cases almost always result in an argument over a part of the Tax Code called “IRC 162”.
Why is IRC 162 so important?
IRC 162 states:
“There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business….”
The IRS has frequently come back to referencing this “trade or business” phrase when allowing other certain deductions and positions, with respect to rental real estate.
In August of 2018, the IRS released what are called “Proposed Regulations”. Proposed Reg’s are written by the IRS, explaining ahead of time how they plan on enforcing rules written by Congress, especially in situations where the code is unclear.
Many taxpayers wrote to the IRS, requesting clarification as to whether they planned on allowing RRE to be grouped under the definition of “trade or business”.
The IRS’ answer? They would be relying on IRC 162 to define a trade or business. In other words, they will most likely disallow the deduction if taxpayer’s attempt to take it on RRE.
They did explicitly state ONE situation where RRE would absolutely qualify. In situations where a taxpayer owns real estate being used by a “normal” business, they would permit the 20% business deduction.
Ex., John the real estate flipper decides to buy a commercial building under an LLC separate from his flipping S-Corp. John’s flipping corporation pays rent to his LLC owning his commercial building. The IRS has explicitly said they will permit the resulting net income to qualify for the 20% deduction.
In any other RRE situation than this, the IRS will point to IRC 162.
OK, so IRC 162 is pretty vague and gives us very little clarity as well. Where else do we go for help?
Answer: The Tax Courts
The tax courts further define “trade or business” as
“…an activity conducted with ‘continuity and regularity’ and with the primary purpose of earning income or making profit.”
The term above comes from a court case that further went on to define a trade or business as an activity that is not sporadic or hobby-like. Per the tax court, simply engaging into a profit is not enough. There must be an ongoing participation and demand from the taxpayer. Passive, turnkey activities likely would not translate well when referencing the tax laws.
So where does that put us with respect to RRE?
It would appear that investors who have real estate portfolios that require continued and regular involvement would make for good qualification for the 20% business deduction.
Consider the sliding scale below for a good illustration of how to determine whether you will qualify:
The most extreme form of passive investment are those who rely on property management to conduct day to day participation and involvement. An investor with one rental under management is extremely unlikely to meet any standard of continual and regular activity.
Many of our clients take the form of a landlord owning 3-4 rentals while assuming all forms of management. Is participation continual and regular? If so, and a good case can be made based on the facts and circumstances, the 20% business deduction may stick. Is participation sporadic? If so, you won’t get far in the tax courts.
A handful of our clients have no day job, and manage their own rental real estate full-time. There is no other source of income. RRE is their only profession and only source of income. There are no managers, no outside parties to relieve the client of continual and regular involvement. In cases like these, the IRS would likely have a difficult time labeling the taxpayer as anything but a trade or business.
So, does RRE qualify? It will likely depend on several factors:
- Taxpayer’s level of involvement (continued/regular vs. sporadic)
- Taxpayer’s alternative sources of income & time commitments elsewhere
- Reliance on, and presence of third parties to conduct normal activities of RRE activity (property managers)
- Maintenance nature of the RRE (A class properties likely require less time and effort, whereas high-maintenance C class properties likely require more)
Furthermore, the deduction isn’t a make-it-or-break-it benefit for most RRE investors. In the example of the taxpayer with 3-4 rental properties, let’s say he nets $10,000 of taxable income. The deduction is $2,000. If the taxpayer is in the 20% bracket, that’s $400 of tax savings.
In short, there’s no crystal clear path to taking the deduction for most RRE investors. Every investor’s situation is different and warrants different analysis of the facts. Years from now, many taxpayers will likely fight their way through the tax courts, providing us with better case law and legal precedent to rely on. Until then, proceed with caution!
Nathaniel Busch, CPA