What the final answer on 20% pass through income tax deduction?

4 Replies

I've been trying to find a definitive answer on whether a landlord (in my case, owner of 4 separate rental units) can take the 20% pass through income tax deduction for tax year 2018 and beyond. I've been reading conflicting opinions online. What the real and final answer as we are beginning to prepare for filing our taxes?

@Benjamin Forest

The only definitive answer and brightline test came via Notice 2019-07.

250 hours or more of "rental services" (as defined in Notice 2019-07) to meet safe harbor 'trade or business' treatment for your rentals.  Otherwise, you must qualify under case law.

Highly advisable to work with your tax CPA/EA to make a determination.

My practice has found most landlords who own at least 3-4 rentals qualify under safe harbor.

If they are showing a net profit and you are in the trade or business than yes.  Most intentional landlords will qualify if they are treating their rentals in a business-like fashion. There is a 250 hour safe harbor; however, I'm finding that most landlords will be using the trade or business threshold. 

Keep in mind your losses matter as those will offset future 199A deductions(20% deduction).

@Benjamin Forest See excerpt from a publication I received just an hour ago.  I hope this helps!  

"Is Schedule E rental income eligible for the 20% pass-through deduction?

Final regulations provide limited guidance, but IRS gives a safe harbor.
The new tax break applies to qualified business income from a trade or business.
The final regs continue to refer to the standard under federal tax code Section 162,
the statute that generally governs the deductibility of trade or business expenses.
Unfortunately, this standard is somewhat unclear in the context of a rental activity.
That’s because it’s based on facts and circumstances specific to each taxpayer.
Among the relevant factors: Type of property leased (commercial or residential),
extent of day-to-day involvement by the lessor or the lessor's agents, lease terms,
number of properties rented and other ancillary services provided under the lease.

The safe harbor applies if at least 250 hours are devoted to the rental activity
by the property owner, employees or independent contractors in a year. Time spent
on repairs, collecting rent, negotiating leases and providing tenant services counts.
Hours put in for arranging financing, constructing long-term capital improvements,
and driving to and from the real estate aren't included in the 250-hour standard.

If the 250-hour test is met, you can treat the rental as a trade or business
for purposes of the 20% pass-through deduction. Separate records and bank accounts
must be maintained. For post-2018 years, contemporaneous records must be kept
that detail the hours, dates and description of the services, and who performed them.
The safe harbor doesn’t apply to property that is leased under a triple net lease
or used as a residence for any part of the year by the lessor or the lessor’s family.
Notice 2019-07 has details on the safe harbor, including how to claim it."

The Kiplinger Tax Letter (ISSN 0023-1762)

This correspondence does not establish an attorney-client or accountant-client relationship

Originally posted by @Benjamin Forest :

I've been trying to find a definitive answer on whether a landlord (in my case, owner of 4 separate rental units) can take the 20% pass through income tax deduction for tax year 2018 and beyond. I've been reading conflicting opinions online. What the real and final answer as we are beginning to prepare for filing our taxes?

the new Safe harbor is an objective test. Meeting trade or business requirement is not. 

If you meet safe harbor, you are good for 20% deduction, if not use these cases to draw the conclusion. 

Generally, to determine whether a rental real estate activity is a trade or business, the courts have considered the taxpayer's activities with respect to the property as well as the taxpayer's intent. In David Keefe, et ux., the Court stated:

In deciding whether a rental property is used in a trade or business or is a capital asset, the Court of Appeals for the Second Circuit has examined the taxpayer's rental-related activities for continuity, regularity, and substance. Among the facts considered are the taxpayer's efforts to rent the property; the maintenance and repairs supplied by the taxpayer or an agent of the taxpayer; the taxpayer's employment of labor to manage the property or provide services to tenants; the purchase of materials; the collection of rent; and the payment of expenses . . . The totality of the facts and circumstances surrounding the use of the property must support a conclusion that the alleged rental activities were sufficient, continuous, and substantial enough to constitute a trade or business with respect to the rental of the property.

Rental Activity Held to Be a Trade or Business..

In the following cases, the court held that the taxpayer's rental of real estate constituted a trade or business.

  • • In Gilford, a taxpayer was held to be in a rental trade or business when she was involved in regular and continuous activity for eight buildings on eight separate parcels of land. Although the taxpayer did not directly conduct any maintenance or management functions, she had a managing agent who carried out these activities; thus, her loss on the sale of the property was an ordinary loss (and not a capital loss, as the taxpayer had claimed).
  • • In Fackler, the taxpayer owned a six-story apartment building. The Court found that managing the building involved continuous activity (such as repairs and furnishing basic utilities), employing labor, and buying materials. So, it was a trade or business, regardless of the fact that the taxpayer, a full-time lawyer, visited the property only once or twice a month for one or two hours each time.
  • • In Murtaugh, the taxpayer was found to be engaged in a trade or business when he purchased and rented two timeshares. The court noted that the taxpayer researched various locations and chose the timeshares based on where he thought he could turn a profit, rather than his personal preferences for a vacation spot. Although the taxpayer did not perform many activities with respect to the timeshares personally, the court found that the seller of the timeshare was acting as the taxpayer's agent when it provided advertising, guest registration, housekeeping, and inventory replenishment in exchange for 40% of the rent receipts on the property. Those activities were sufficient to rise to the level of a trade or business.
  • • In Estate of Gibney, the taxpayer foreclosed on rental properties (real estate) and operated the properties as rentals until they were sold. The Tax Court determined that the rental activity was a trade or business, holding that ordinarily the operation of rental property constitutes a trade or business, and the property itself is not a capital asset. The Court rejected the IRS's contention that this case was different and the rental was not a trade or business because (a) the acquisition of the property was involuntary, (b) the operation of the property was not intended to be of long duration, (c) only a small part of decedent's income was derived from the rental of real estate, and (d) the net result of the operation of the particular rental properties was a loss.
  • • Lagreide was a case involving a net operating loss carryback and recomputation of the correct net operating loss. The taxpayer did not reduce the business loss by the amount of wages and rental real estate net income received. The Court upheld the IRS's position that the taxpayer must reduce the net operating loss since the rental real estate net income and the wages each constituted a “trade or business.” Regarding the rental, the Court stated that:
  • It is clear from the facts that the real estate was devoted to rental purposes, and we have repeatedly held that such use constitutes use of the property in trade or business, regardless of whether or not it is the only property so used. (citations omitted) We add that the use of the property in trade or business was, upon the facts, an operation of the trade or business in which it was so used (citation omitted). It is clear, also, that the business was “regularly” carried on, there having been no deviation at any time, from the obviously planned use.

Rental Activity Was Not a Trade a Business..

The following cases show situations when the courts held the taxpayer's rental real estate activity did not rise to the level of a trade or business.

  • • In Grier, the taxpayer inherited a home that was leased to a tenant. The existing tenant continued to occupy the residence and pay rent until the house was sold 14 years later. While the taxpayer did pay for upkeep and repairs during that time (generally after receiving and approving estimates provided by the tenant), the court ruled that the house was a capital asset in the taxpayer's hands because it did not require regular and continuous activity to manage.
  • • In Jackson, a taxpayer who acquired property with the intent of selling it could not change its status from a capital asset to an asset used in a trade or business merely by attempting to rent it out before the sale. In this case, the property had suffered severe damage, and although the taxpayer did offer the property "for sale or lease," he never made the repairs that would have been necessary for a tenant to occupy it.
  • • In Union National Bank of Troyy, the bank was executor for property owned by decedent. The court ruled that capital loss resulted from sale of interest in rented-out real property with which taxpayer had only minimal and passive contact. He had no obligations to maintain or repair, or pay taxes or other assessments. He had nothing to do, directly or indirectly, with its management or operation. Thus, the court rejected the IRS's argument that the property was used in the taxpayer's trade or business, that he had an ordinary loss, and that the capital loss carryover should be disallowed.