One of the most substantial changes to the tax code included with the Tax Cuts and Jobs Act (TCJA) is the ability (potentially) to deduct 20% of qualified business income (QBI). This is referred to as the Section 199A deduction and goes into effect for 2018. Section 199A is generally reserved for pass through income from partnerships, trusts and S Corporations as well as business income of sole proprietorships.
To get the deduction, you must clear several hurdles and meet certain definitions, most of which we won’t get into at this time. But we will touch on one definition that “appears” to be quite clear: in order for any activity to qualify for the Section 199A deduction, the activity must rise to the level of a trade or business. Unfortunately, the term “trade or business” is not clearly defined by the tax code. The courts have attempted to further define it by saying, “to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity…” So, how would this apply to a real estate rental business? Does it rise to the level of a trade or business for purposes of qualifying for the deduction? Like all things tax related, it depends.
It seems likely that a triple-net lease arrangement would not qualify as a trade or business. By definition, the tenant is covering the costs of the real estate including taxes, insurance, maintenance and utilities. This leaves collecting rent from the tenant as one of the only responsibilities of the landlord. Courts have consistently agreed that triple-net lease arrangements do not allow the taxpayer to be involved with continuity and regularity and therefore, it is not a trade or business.
It is also clear that rentals that do not rise to the level of a trade or business, will qualify anyway if they are renting to a qualified trade or business under common control. This is known as a “self-rental.” Common control for these purposes is defined as the same person or group of persons, directly or indirectly, owning 50% or more of each trade or business to be aggregated. Triple-net leases that meet the definition of a self-rental would be thrown back into the trade or business category, potentially preserving the 20% deduction.
So, outside of single triple-net leases and self-rentals, what will it take for your rental activity to be considered a trade or business? It isn’t clear at this point, but be prepared to track your time and the time of others. If you can show you’re involved with the rental activity with continuity and regularity, you should be fine.
Scott W. Clouse, CPA