Rental Real Estate Income Qualifying for Section 199A Deduction

Recent tax legislation added a new tax deduction for business owners. It permits individuals, estates, and trusts to deduct up to 20% of their “qualified business income.” You may have heard a lot of talk in the news about a new deduction for “pass-through” income, but it’s actually available for qualified business income from a sole proprietorship, as well as from pass-through entities such as partnerships, LLCs, and S corporations.

One question that has been on everyone’s mind is whether this new deduction applies to rental real estate income and losses. Regulations recently proposed by the IRS provide some guidance. Under these rules, only income from a qualified trade or business is eligible for the deduction. A trade or business is an activity carried on regularly and continuously for the purpose of making a profit. Sporadic or hobby activities don’t qualify. So, landlords who spend substantial amounts of time managing rental properties will most likely qualify for the deduction.

The IRS and courts generally use a facts and circumstances test to determine if a rental real estate activity is a trade or business (as opposed to an investment). Various factors are considered, including the following:

  • The landlord’s efforts to rent the property.

  • The maintenance and repairs supplied by the landlord (or an agent of the landlord).

  • The landlord’s employment of labor to manage the property or provide services to tenants.

  • The purchase of materials, the payment of expenses, and the collection of rent.

These factors must show that the rental activities are regular and continuous enough to constitute a trade or business. Note that landlords who use an agent to manage the properties can still be engaged in a trade or business.

The IRS and courts also consider the type of lease signed by the parties. One arrangement that is of particular concern is the triple net lease. This is where the tenant pays rent, as well as real estate taxes, building insurance, and maintenance costs. In this scenario, it might be difficult to argue that the property owner is regularly and continuously involved in a trade or business.

There is a special rule, however, for self-rentals. Under rules proposed by the IRS, the rental or licensing of property to a commonly controlled trade or business is treated as a trade or business for purposes of the qualified business income deduction. For this rule to apply, the same person or group of persons must own 50% or more of the rental activity and the related trade or business. Note that a person is considered to own an interest in a trade or business held by a spouse, child, grandchild, and parent.