The Internal Revenue Code is a labyrinth — you might think that you have visited every room only to discover an opening that leads to yet another maze to explore.
Rental real estate activities are found in several of the labyrinth rooms of the Code. They can be passive (by default), recharacterized as nonpassive (e.g., net rental income generated from leasing to the taxpayer's materially participating business), or materially participating (e.g., a real estate professional who meets the material participation tests). Status under the passive activity rules dictates the status for purposes of the net investment income tax. Rental real estate activities may be a trade or business (usually) or an investment (in the extreme, a triple-net long-term lease of bare ground). They may generate qualified business income (QBI) (for the trade or business activities) even though the owner is passive. If the real estate activity generates active trade or business income or loss, that income or loss enters into the Sec. 179 computation. Usually the rental real estate does not generate self-employment income (or loss), regardless of status for passive activities, QBI, or Sec. 179.
Rental real estate and passive activities
Without getting too deep into the labyrinth (there is no intention here of writing a book), rental real estate activities default to passive status.1 Real estate rentals are also subject to recharacterization rules for passive activity purposes.2 For example, the net rental income from substantially nondepreciable property is characterized as nonpassive, but a net loss is passive.3 The result is the same if the owner of the rental real estate leases the property to a trade or business in which the taxpayer materially participates.4 The recharacterization rules apply regardless of whether the rental activity rises to the level of a trade or business (more on that later).
A real estate professional has the opportunity to have the activity treated as nonpassive if he or she materially participates in the rental real estate activity.5 A real estate professional is one who spends more than one-half of her personal services performed in all trades or businesses during the year in real property trades or businesses in which she materially participates. She must also perform more than 750 hours of services during the year in real property trades or businesses in which she materially participates. The taxpayer alone must meet both tests because there is no spousal attribution.6 Counting and documenting hours is important, not only for the real property trades or businesses but for other trades or businesses as well, in order to properly determine the denominator of the more-than-50% test.
Real property trades or businesses are those involved in development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, and brokerage of real property.7 The regulations do not further define these terms. The real estate professional status merely "turns off" the default status of rental real estate as a passive activity.8 The taxpayer must then separately establish nonpassive status by material participation or, for an activity generating net income, significant participation.9 Other recharacterization provisions may result in nonpassive status.
Rental real estate and the net investment income tax
The net investment income tax applies to the lesser of net investment income or the excess of adjusted gross income (AGI) over the threshold amount.10 The term "net investment income" is a misnomer. It includes interest, dividends, annuities, royalties, rents, other gross income, and net gain (to the extent includible in taxable income) from the disposition of property, of a trade or business that is a passive activity with respect to the taxpayer, less the deductions allocable to those items of gross income or net gain.11 Thus, net investment income may include business income, if that business income is passive.
A taxpayer is not subject to the net investment income tax (i.e., the income is not net investment income) on rental real estate activities if they are not passive.12 Rental real estate activity income may be recharacterized as nonpassive if it is from a significant participation activity (an activity in which the taxpayer participates for over 100 hours but does not materially participate), property rented incidental to a development activity, or a self-rental.13 If so recharacterized under the passive activity rules, the income is also not net investment income for purposes of the net investment income tax.
The real estate rental activity of a real estate professional that is not per se passive will be nonpassive if the taxpayer establishes material participation or significant participation in the real estate rental activity. If considered nonpassive under the passive activity rules, the income is also not net investment income.14
Not all rental real estate activities recharacterized as nonpassive will escape the net investment income tax labyrinth. The rental of substantially nondepreciable property (less than 30% of the unadjusted basis of the property used in the rental activity is depreciable) is not from a passive activity15 but is considered as property held for investment.16 The rental of substantially nondepreciable property will be subject to the net investment income tax unless it is also a self-rental property.
Rental real estate and QBI
Solely for purposes of the QBI deduction, the rental of tangible property to a trade or business that the taxpayer (or a passthrough entity) conducts that is commonly owned is treated as a trade or business.17 The same person or group of persons must own, directly or by attribution under Sec. 267(b) or 707(b), at least 50% of each trade or business and the rental activity. This deemed trade or business status does not include a rental to a C corporation trade or business.18 Meeting the commonly owned test satisfies the trade or business requirement and qualifies the activity for the QBI deduction, even if the minority owner of the rental activity has no ownership in the trade or business activity to which the property is leased.
Even if the taxpayer does not meet the requirements for the deemed trade or business (e.g., the operating business to which the property is leased operates as a C corporation, or is not commonly owned with the business), the activity may meet the trade or business standard. A taxpayer is engaged in a trade or business when the taxpayer is involved in the activity with continuity and regularity, and the taxpayer's primary purpose for engaging in the activity is for income or profit.19 The rental of property is not, as a matter of law, precluded from being a trade or business, and under appropriate circumstances, the long-standing definition of "trade or business" includes the rental of even one property.20
The rental of real estate is a trade or business if the taxpayer-lessor engages in regular and continuous activity in relation to the property,21 even if the taxpayer rents only a single piece of real estate.22 The owner may carry on these activities through an agent as well as personally. View this as a qualitative test versus the quantitative test used for passive activities (e.g., counting hours).
The QBI regulations refer to a trade or business by reference to Sec. 162. Income is self-employment income only if the activity rises to the level of a trade or business. The phrase "trade or business" is used for determining the net earnings from self-employment.23 It appears clear that if the taxpayer's income is self-employment income, it is also trade or business income, which is QBI, unless specifically excepted (e.g., guaranteed payments for the use of capital received by a partner in a partnership are trade or business income that is not QBI24). Not all QBI, though, is self-employment income. Rental real estate income may be derived from a trade or business that is not subject to self-employment tax, due to the exception for rental real estate.25 A landlord engaging in regular and continuous activity in relation to the property is engaged in the trade or business of renting real estate; the income is not subject to self-employment tax, however.
QBI, of course, does not require material participation, or any participation, by the owner of the activity.26 The owner's participation may be passive. The passive activity temporary regulations (mostly in place since 1988) require the owner to participate under one (or more) of seven tests, four of which require the owner to count hours.27 Hours performed by the owner's agents or employees do not count in the passive activity tests. Participation that satisfies standards not contained in the passive activity rules generally is not taken into account in determining whether the owner materially participates. This includes self-employment and alternate valuation for estate tax purposes.28
Rental real estate and Sec. 179
The regulations are clear that a lessor can elect Sec. 179 for leased property as long as the lessor satisfies the active trade or business29 and other requirements. The law known as the Tax Cuts and Jobs Act30 also expanded the definition of Sec. 179 property by removing the exclusion for Sec. 50(b)(2) property — property used predominantly to furnish lodging or in connection with lodging. The committee report states: "Property used predominantly to furnish lodging or in connection with furnishing lodging generally includes, for example, beds and other furniture, refrigerators, ranges, and other equipment used in the living quarters of a lodging facility such as an apartment house, dormitory, or any other facility (or part of a facility) where sleeping accommodations are provided and let."31 In the context of apartment buildings, this tangible property is subject to a lease. Consequently, it is clear that rental real estate lessors can claim the Sec. 179 deduction for leased property.
Noncorporate lessors, however, are subject to additional limitations. To elect the Sec. 179 deduction, a noncorporate lessor must have either manufactured or produced the leased property; or the lease term must be less than 50% of the class life of the property and during the first 12 months of the lease the lessor has Sec. 162 deductions with respect to the property in excess of 15% of the rental income produced by the property.32 An apartment owner might qualify for this provision if she hires a manager (labor expense) and/or has sufficient expenses under Sec. 162 (such as maintenance, utilities, pool costs, etc.) that exceed 15% of gross rental income.33 If so, the election to expense certain depreciable business assets should be allowed for the property acquired in the year that the qualifying expenses exceed 15% of gross rental income. (An S corporation is treated as a corporation for this purpose.)
Active trade or business income comes into play for another aspect of rental real estate. If the taxpayer's rental real estate activity rises to the level of a trade or business, the active conduct of that trade or business generates income or loss that, in total, may limit the taxpayer's expensing election deduction against other business income.34 Employees are considered to be engaged in the active conduct of the trade or business of their employment.35 The taxable income from the active trades or businesses limitation is applied to the aggregate income of both spouses if they file a joint income tax return.36
The amount of involvement needed to rise to the level of "active" is not defined in the Code or regulations. Determining whether the trade or business is actively conducted by the taxpayer is made from all the facts and circumstances. The regulations state the purpose of the active conduct requirement is to prevent a passive investor in a trade or business from deducting Sec. 179 expense against taxable income derived from that trade or business. A taxpayer is considered actively conducting a business if the taxpayer meaningfully participates in the management or operations of the business. "A mere passive investor in a trade or business does not actively conduct the trade or business."37
The "active conduct" test was discussed by commentators to proposed regulations after the Tax Reform Act of 1986.38 Commentators noted that the regulation should state more specifically that the terms "active" and "passive" do not have the same meaning as in the passive activity rules. Treasury responded that the definition of the active conduct standard for expensing is a different standard than the material participation standard under Sec. 469, but it was not deemed necessary to modify the regulations to specifically state that.39
Material participation is not required for the active trade or business requirement and neither is significant participation. These terms focus mostly on hours of involvement by the taxpayer. "Active conduct" is a low standard. Being involved in making decisions should suffice.
Example: K has wage income of $60,000; a Schedule C, Profit or Loss From Business, sole proprietorship loss of $100,000 in which K materially participates; Sec. 179 deductions from the sole proprietorship of $90,000; and $200,000 of income from his apartment building. At first glance, K does not have active trade or business income ($60,000 - $100,000 = -$40,000). However, an apartment complex is clearly a trade or business activity, requiring involvement directly by K or his agent (e.g., the complex manager). His active management of the apartment complex (he oversees the manager of the complex) is sufficient to classify the apartment income as active trade or business income. Rather than a $40,000 loss from an active trade or business on his Form 1040, U.S. Individual Income Tax Return, K has $160,000 active trade or business income. The Sec. 179 deduction on the Schedule C is allowed.
Partnership and S corporation reporting
Schedule K-1 (Form 1065), Partner's Share of Income, Deductions, Credits, Etc., box 2, reporting of a rental activity, should not prohibit the taxpayer from qualifying to claim the Sec. 179 deduction for leased property. Form 8825, Rental Real Estate Income and Expenses of a Partnership or an S Corporation, is for real estate rentals, which do not enter into the self-employment income computation. All rental real estate activities are reported on Form 8825, whether from a trade or business or held for the production of income. Form 8825 reporting may be passive, but it is appropriate for nonpassive real estate rentals as well.
For example, some of the partners may be real estate professionals. While a taxpayer's status as a real estate professional is determined at the individual level, the status of a rental of property as a real estate rental is determined at the partnership level. Regardless of passive activity status, the rental real estate belongs on Form 8825 (and for an individual, on Schedule E, Supplemental Income or Loss). Sec. 179 deductions are not reported on Form 8825, however. They are a separately stated item of the partnership or S corporation.
Trade or business activities conducted through a partnership are reported on Form 1065, U.S. Return of Partnership Income. "Mere co-ownership of property that is maintained and leased or rented is not a partnership. However, if the co-owners provide services to the tenants, a partnership exists."40 If the parties are mere holders of undivided interests in real estate, a partnership does not exist for tax purposes. In that case, it may be best if the parties did not file a partnership tax return so that individual partners may determine depreciation and accounting methods best suited for their situation.
The reporting of trade or business rental real estate on Forms 8825, to transfer to line 2 of Schedule K, "Partners' Distributive Share Items," of Form 1065, is supported by the instructions for line 9 of Form 8825. This instruction discusses the possible application of the new business interest expense limitation under Sec. 163(j). This limitation applies only to trade or business activities. A trade or business for Sec. 163(j) purposes is defined under Sec. 162, the same standard as for Sec. 199A. Consequently, it is clear the IRS expects Form 8825 reporting of rental activities that rise to trade or business status.
Bringing this back to Sec. 179, individual taxpayers still must pass the noncorporate lessor rules. That may be possible if the lessor incurs sufficient expenses other than interest, taxes, and depreciation. Regardless, however, the income or loss affects the computation of active trade or business income for Sec. 179 purposes.
Rental real estate and active conduct of a trade or business
Corporate reorganizations involving divisions may include the distribution of stock and securities of a controlled corporation.41 To qualify under Sec. 355, active businesses must be involved.42 The active conduct of a trade or business does not include the ownership and operation, including leasing, of real or personal property used in a trade or business unless the owner performs significant services in operating and managing the property.43 In the corporate context, the management services must be conducted by the corporation's employees, not independent contractors.44
The IRS ruled that rental by a manufacturing business of an old factory building and several other small properties, which produced little to no income, was incidental to the manufacturing business and did not constitute the active conduct of a separate trade or business.45 The IRS and Treasury are studying how to apply the active trade or business test and whether the lack of income generated by the stated activities disqualifies the activity from trade or business status.46 The author believes this study is part of an attempt by the IRS and Treasury to conform the definition of "trade or business" to provide consistency across Chapter 1 of the Code.
An S corporation with accumulated earnings and profits may be subject to the excess passive income tax when more than 25% of its gross receipts are from passive investment income.47 Passive investment income has the same meaning as for eligibility for the S corporation election.48 If the S corporation with accumulated earnings and profits has passive investment income that exceeds 25% of gross receipts for three consecutive years, the S election is terminated.49 "Passive investment income" means gross receipts from royalties, rents, dividends, interest, and annuities.50 Rents derived in the active trade or business of renting property are not included. Based on facts and circumstances, the trade or business of renting property exists if the corporation provides significant services, or substantial costs are incurred in the rental businesses. The number of persons employed to provide the services and the types and amounts of costs and expenses incurred other than depreciation are factors.51
The provision of significant services is not addressed in further detail for corporate reorganizations or the S corporation excess passive income tax. The significant services might be rendered with respect to the property (e.g., maintenance and management of relationship with the tenants) or perhaps with respect to the tenant of the property (security services, janitorial services, and utilities). Clearly the operation of a hotel, which might be better described as providing a license to the guest to occupy a room and use hotel services, is a provision of services to the guest. Services to guests may include daily linen changes, room cleaning, and perhaps turn-down services. The operation of an apartment complex, however, likely is not viewed as providing significant services to the tenants. The apartment complex may provide access to specific amenities, such as a pool, fitness room, and laundry room. These are not services to the tenants unless something more is provided, such as lifeguard or laundry services for the tenants.
Rental real estate and self-employment income
Self-employment tax is imposed on an individual's self-employment income.52 "Self-employment income" includes the net earnings from self-employment derived by an individual,53 subject to certain limitations not relevant here.
The term "net earnings from self-employment" means the gross income derived by an individual from any trade or business carried on by that individual, less the deductions allowed that are allocable to the trade or business, with certain exceptions.54 Rentals from real estate and from personal property leased with the real estate (including rentals paid in crop shares) net of deductions are excluded from self-employment income. This exclusion does not apply if the rentals are received in the course of a trade or business of a real estate dealer.55
Payments for the use or occupancy of entire private residences or living quarters in multiple-housing units are generally rentals from real estate. Payments for the use or occupancy of rooms or other space, where services are rendered for occupants, will not constitute a rental from real estate. These services include the use or occupancy of rooms (as opposed to the entire private residence) and the furnishing of hotel services and are beyond the protection of the real estate rental exclusion. Services are considered rendered to the occupant if they are primarily for the occupant's convenience and are other than those services usually or customarily rendered in connection with the rental of rooms or other space for occupancy only. Maid service is such a service. Heat and light and cleaning the public entrance, exits, stairways, and lobbies are not services rendered to the occupants. Likewise, the collection of trash is not considered a service rendered to the occupant.56
In most cases, it is obvious when the rental of real estate generates self-employment income. At some point, the provision of services as part of the rental of self-storage units or homes or apartments through platforms such as Airbnb will cause the income received to be self-employment income. Providing services to tenants (check-in, checkout, security, cleaning during the occupancy) may suffice to expose the owner-operator to the self-employment tax.
The end of the maze
The rental real estate labyrinth discussed here does not address the many nuances associated with international taxation. And it certainly does not explore each and every passageway through rental real estate taxation on the domestic side.
A rental real estate activity rising to the level of a trade or business does not involve the self-employment tax. Self-employment involves more than providing services associated with the property. If the activity does not generate self-employment income, the rental real estate activities should be reported on Schedule E of Form 1040 if the owner is an individual. If the owner is a partnership or S corporation, the amounts belong on Form 8825, to transfer to Schedule K, line 2, of Form 1065. Self-employment businesses (hotels and rental real estate dealers) are reported on Schedule C (Form 1040) or on page 1 of Form 1065 or Form 1120-S, U.S. Income Tax Return for an S Corporation.
The status of rental real estate for purposes of the self-employment tax does not determine its status for other purposes of the Code. A rental real estate activity rising to the level of a trade or business opens the door for a possible QBI deduction and expensing under Sec. 179, but this does not mean or imply that the income from the activity is subject to self-employment tax. An otherwise nonbusiness rental real estate activity might qualify for the QBI deduction if it is commonly owned with a non-C corporation operating trade or business, which is determined at the activity level. A taxpayer, though, must personally actively conduct the trade or business in order to qualify for deductions under Sec. 179.
2Temp. Regs. Sec. 1.469-2T(f).
3Temp. Regs. Sec. 1.469-2T(f)(3).
4Regs. Sec. 1.469-2(f)(6).
5Sec. 469(c)(7), which provides that Sec. 469(c)(2) does not apply.
8Sec. 469(c)(7)(A)(i), stating that Sec. 469(c)(2) does not apply to a rental real estate activity. Sec. 469(c)(2) provides the default status for any rental activity.
9See Temp. Regs. Sec. 1.469-2T(f)(2).
13Regs. Sec. 1.1411-5(b)(2)(i). See Temp. Regs. Sec. 1.469-2T(f)(2) and Regs. Secs. 1.469-2(f)(5) and 1.469-2(f)(6) for the definitions of these terms.
14The net investment income tax applies to a passive activity and to the trade or business of a trader trading in financial instruments. See Regs. Sec. 1.1411-5(a). As a result, if the real estate professional is active in the trade or business of being a real estate professional, the income is not net investment income.
15Temp. Regs. Sec. 1.469-2T(f)(3).
16Regs. Sec. 1.469-2(f)(10).
17Regs. Sec. 1.199A-1(b)(14); Regs. Sec. 1.199A-4(b)(1)(i).
18Regs. Sec. 1.199A-4(b)(1)(i).
19Groetzinger, 480 U.S. 23 (1987).
20Curphey, 73 T.C. 766 (1980).
21Alvary, 302 F.2d 790 (2d Cir. 1962), rev'g No. 60-Civ. 1029 (S.D.N.Y. 5/19/61).
22Lagreide, 23 T.C. 508 (1954).
24Regs. Sec. 1.199A-3(b)(1)(ii); Regs. Sec. 1.199A-3(b)(2)(ii)(I).
27Temp. Regs. Sec. 1.469-5T(a).
28Temp. Regs. Sec. 1.469-5T(b)(2)(i).
29Regs. Sec. 1.179-1(i)(1).
31Joint Committee on Taxation, General Explanation of Public Law 115-97 (JCS-1-18), p. 106, fn. 418 (Dec. 20, 2018).
33Interest expense is deductible under Sec. 163. Certain taxes are deductible under Sec. 164. Secs. 167 and 168 allow depreciation expense. Taxes, interest, and depreciation are not included in the 15% test.
34Sec. 179(b)(3); Regs. Sec. 1.179-2(c)(1).
35Regs. Sec. 1.179-2(c)(6)(iv).
36Regs. Sec. 1.179-2(c)(7).
37Regs. Sec. 1.179-2(c)(6)(ii).
38Tax Reform Act of 1986, P.L. 99-514.
40Instructions, Form 1065, page 3.
43Regs. Sec. 1.355-3(b)(2)(iv)(B).
44Regs. Sec. 1.355-3(b)(2)(iii).
45Rev. Rul. 57-464.
46Rev. Rul. 2019-9, suspending Rev. Ruls. 57-464 and 57-492.
51Regs. Sec. 1.1362-2(c)(5)(ii)(B)(2).
56Regs. Sec. 1.1402(a)-4(c)(2).
|Christopher W. Hesse, CPA, is a principal in the National Tax Office of CLA (CliftonLarsonAllen LLP). He is the chair of the AICPA Tax Executive Committee. For more information on this article, contact email@example.com.