Defining a trade or business is easy for the most part, however certain activities are murky and one of them is rental properties. On one hand an argument that rental property income is already tax advantaged can be made since it is not subject to self-employment taxes (Social Security and Medicare). However, if it were subject to SE tax, people would simply create management entities, elect S Corp status, ding the rental a management fee and achieve a Section 199A deduction that way. This is perhaps one reason the IRS isn’t raising a big stink on rental properties.
Also, in Commissioner v. Groetzinger, 480 U.S. 23 (107 S.Ct. 980, 94 L.Ed.2d 25), the U.S. Supreme Court in 1987 held that for an activity to meet the definition of a trade or business it must be engaged to a) earn a profit and b) with some regularity and continuity. This is also most rental property owners, even if it is just one house.
And… don’t read too much into the words “earn a profit.” This does not mean it must earn a profit… but your intentions for conducting the activity is to earn a profit. Whether you earn a profit or not does not necessarily alter your intentions. Make sense? In other words, “I wanna earn a profit. I’m doing all the right things to make a buck, yo, but right now times are tight and this depreciation thing is killing me.”
The IRS and the Treasury Department recognized this conundrum so they released IRS Notice 2019-7. In that Notice they defined a safe harbor for taking the Section 199A deduction for rental properties-
Solely for the purposes of section 199A, a rental real estate enterprise will be treated as a trade or business if the following requirements are satisfied during the taxable year with respect to the rental real estate enterprise:
There are some other devils in the details such as not being able to combine commercial and residential rentals into a single enterprise, and there are lease type rules as well.
Self-rentals pose an interesting situation. For example, you own some equipment personally and lease it back to your business. Provided the arrangement is at market rates, we believe this still qualifies for the Section 199A deduction as a rental business for two reasons. First, how is this any different than an external business who leases the equipment to unrelated parties? That ordinary income would qualify. Second, you are moving dollars from your right pocket to your left pocket, and absent of the SSTB designation, you are just swapping Section 199A dollars.
Caution: the self-rental consideration has not been challenged in a tax court; there is a lot of risk since your Section 199A deduction on a self-rental is predicated upon being able to demonstrate that it rises to the level of a trade or business.
The IRS was concerned that a specified service trade or business (SSTB) could shift income that would normally not qualify for a Section 199A deduction into self-rental income that may qualify. This was part of the “crack and pack” strategy of splitting up an entity into SSTB and non-SSTB operations, thus being able to qualify for a Section 199A deduction on the non-SSTB operation (provided you hit those income limits that required the secondary SSTB test with the sliding scale of phaseout).
The proposed regulations 1.199A-5(c)(2) added provisions preventing this. So, if an accountant owns the firm and the building in separate entities, the self-rental income becomes “tainted” and is considered SSTB income. This is because both entities have greater than 50% common control. And No, you cannot have your spouse own the building and you own the SSTB business; attribution rules get in the way and state that you both own everything. Again, common control. Here is a blurb right from the regulations-
Example. Law Firm is a partnership that provides legal services to clients, owns its own office building and employs its own administrative staff. Law Firm divides into three partnerships. Partnership 1 performs legal services to clients. Partnership 2 owns the office building and rents the entire building to Partnership 1. Partnership 3 employs the administrative staff and through a contract with Partnership 1 provides administrative services to Partnership 1 in exchange for fees. All three of the partnerships are owned by the same people (the original owners of Law Firm). Because there is 50% or more common ownership of each of the three partnerships, Partnership 2 provides substantially all of its property to Partnership 1, and Partnership 3 provides substantially all of its services to Partnership 1, Partnerships 1, 2, and 3 will be treated as one SSTB under paragraph (a)(6) of this section.
This is unfortunate in our opinion. This same law firm leases office space from an unrelated party; the law firm might not qualify for the Section 199A deduction because of SSTB income limitations but the landlord might. Provided the rent charged in a self-rental situation is market rent, why can’t the law firm also be a landlord? We want to say Yes, but the IRS says No. We believe this will be challenged in some fashion since it appears on its face to be discriminatory, and provided the self-rental is at market rates it appears to treat two rental operations differently depending on the relationship between landlord and tenant.
For non-specified service trade or business situations, the big takeaway is make sure this transaction has all the appearances of an arms-length transaction, fair dealings (versus self-serving), fair market pricing, etc.
So, as of right now, rental property owners are able to calculate and use the Section 199A qualified business income deduction if they meet the requirements in IRS Notice 2019-7. Also, be cautious when considering the self-rental situation. Rental property ownership is also where depreciable assets come into play for determining the Section 199A limitations. No, you do not need to pay a W-2 salary from your rental property to enjoy the qualified business income deduction since your depreciable assets should trump this limitation.
Taxpayer's Comprehensive Guide to LLCs and S Corps : 2019 Edition