The Regs are out- So Does the §199A 20% Deduction apply to my Rental Income?!

Today was a very exciting day...for accountants mostly. The new regulations related to the §199A pass-through deduction were released! 

For those who don't know, the §199A deduction allows a 20% deduction on pass-through income (subject to some limitations, but that's a whole different story). This means your LLC income, REIT dividends, partnership income, S corp income - mostly everything except for C-Corp income. 

The reason for the §199A deduction was to level the playing field when C-Corps were changed to having one, lower tax rate on all income beginning in 2018. To prevent this from being un-fairly beneficial over all over entity options- they put into play a 20% deduction for other entities.  

 

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So back to the topic at hand....does rental income qualify? 

When I say rental Income ....I'm talking just Schedule E, passive rentals. Someone who owns one or more long term rentals, and who isn't a real estate professional per the IRS' definition. 

When the §199A deduction was first released in January there were countless articles stating it would apply to Rental Income. But ehhhh....this may not be the case. 

Everyone was waiting on today's regulations to offer clarification on this mater. 

 

Accountants everywhere to the IRS: Does the new §199A deduciton apply to Schedule E rentals?!? Could you give us a yes or no?
The IRS: Here is a pie in a field in Cleveland. 

 

Basically....Even after reading all 138 pages of the new regulations- It's still not clear. 

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The only reference made to rental property with regard to the §199A deduction came down to this: 

  • The §199A deduction is using the code section §162 definition of trade or business Income 
  • Rental Income, which doesn't qualify business income per section §162,  is being allowed an an exception for this deduction 
  • ONLY when it's basically rented to a business you also own, which on its own qualifies for the §199A deduction

Unfortunately- a similar issue arose in 2013 with the passing of new §1411 regulations which related to a rental income classifying as trade or business income. The regulations at that point also failed to clearly define trade or business as it related to real estate activities. 

 

At this point there is no definitive answer. The hope is that over the next few weeks further guidance is provided regarding the issue.

Ultimately, they didn't directly address it- however historically, they never have.

So we're in a gray area where we'll need to look at individual circumstances and if it meets the level of qualifying as a trade or business. 

 

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But here are some parting thoughts....

  • Someone who is a Real Estate Professional has a good shot of meeting the section §162 definition of a trade or business, which could potentially allow the 20% deduction to be used on their Schedule E residential rentals.

 

  • Last minute changes to the deduction specifically added wording expanding the limitation to go beyond a wage limitation- to one that included a property basis limitation.  " 25% of W-2 wages plus 2.5% of the un-adjusted basis of “qualified property.”' Many are looking at this with the belief that it's purpose was to ensure rental income was also inclusive in the deduciton. 

 

  • Someone who is not necessarily a Real Estate Professional, but who self manages multiple rentals, could potentially make an argument for reaching the level of trade or business per section §162 of the revenue code, which could potentially allow the 20% deduction to be used on their Schedule E residential rentals.

 

  • Tax courts have been fairly ambiguous with how they rule regarding if rental income qualifies as being a trade or business. Tax cases dating back to the 1940s have held that renting even a single property may constitute a trade or business

 

  • The IRS indicated in Letter Ruling 8350008  that it would look at a  taxpayer’s efforts in managing a rental property to determine whether the rental activity constituted a trade or business. Again, we're coming down to a facts and circumstances test.

 

  • The Tax Court stated that "We accept the fact that to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit.” - Groetzinger, 480 U.S. 23, 35 (1987). Again, leaving open to interpretation at what point a trade or business is active. 

 

  • Schedule E Rental Income as it stands receives the benefit of not being subject to 15.3% self employment tax, many argue this alone disqualifies it as qualifying business income for the 20% deduction

 

  • Short term rentals which provide services are already being treated as a trade or business subject to the 15.3% self employment tax- these short term rentals which are reported on Schedule C, will likely qualify for the 20% pass through deduction. 

 

  • There may be planning opportunities with regard to entity structuring and lease arrangements that would allow a deduction per the current regulations 

 

This is definitely something I'll be keeping an eye on and will update this post as new guidance is provided.