Section 199A 20% "Pass-through" Deduction and Rental Real Estate
Section 199A was added to the Internal Revenue Code under the Tax Cuts and Jobs Act of 2017 to provide non-corporate taxpayers with a 20% deduction from income attributable to qualifying trades or businesses. One question under the new law is whether the definition of a “trade or business” would include a property owner who collects rent and performs only incidental duties under a lease contract with a tenant.
The tax law indicates that if a taxpayer has an active business, such as a restaurant or an engineering firm, and directly or indirectly leases property to that business, then the net income from the rental is considered to be a qualifying trade or business income for Section 199A purposes. Conversely, where the tenant is NOT an active business that is affiliated by at least 50% ownership with the landlord, then the interpretation of the term “trade or business” has to come from a review of Section 162 of the Internal Revenue Code.
Section 162 dates back to 1926, and controls when a taxpayer can take deductions for expenses incurred in an “active trade or business.” Section 162, however, does not define the term “trade or business” and, therefore, relevant case law has to be reviewed for guidance. The court cases interpreting Section 162 have not always been kind to passive property owners. In particular, there needs to be something more than a long-term triple net lease where a landlord simply collects rent and doesn’t do much else for the rental to qualify as a trade or business. A property owner who provides active management relating to a particular building, or at least administers common area expenses, should probably be able to take Section 199A deduction, but someone who simply bought a building that is triple-net-leased to a large corporation where the tenant does pretty much everything and simply sends a check to the property owner will probably not qualify, although even this is not 100% clear.
In summary, the case law indicates that if the landlord has “regular and continuous” involvement with the rental property, it will most likely qualify for the Sec. 199A deduction. Where the involvement is sporadic, non-recurring, and/or non-devotional (such as under most triple-net-lease arrangements), it will likely not qualify under Sec. 199A. The taxpayers need to review available guidance and make an informed decision on whether or not they believe their rental business qualifies for Sec. 199A deduction given the inherent ambiguity in the tax law.
As an alternative, the IRS recently issued Notice 2019-7, in which it establishes safe harbor criteria by which taxpayers are able to qualify their rental as a trade or business. It is a proposed revenue procedure on which taxpayers can rely until it is finalized. Needless to say, the procedure in its current form appears to have a very limited scope, availability, and effect. I believe that there are a lot of qualifying rental businesses that would not meet the narrow safe-harbor criteria proposed by the IRS. We will keep an eye on future developments in this area.