You move to a new city and rent out your condo for a year, or post your apartment on Airbnb. Can you write 20 percent of that income off your taxes, using the new deduction created by the 2017 tax act?
The answer isn’t clear. Recent Internal Revenue Service proposed rules say “real estate agents and brokers” are not among the “specified service” businesses excluded from the deduction beyond certain income levels. The write-off for pass-through businesses—organized as sole proprietorships, S corporations, limited liability companies, and partnerships, all taxed at the individual owner level—can reduce the top rate to 29.6 percent from 37 percent.
But can people who rent out their vacation houses or former homes qualify? Or owners using third-party websites like Airbnb Inc. or HomeAway Inc.? Or landlords with little involvement in their tenants’ living situations and property upkeep? What about a business that owns a building with a parking lot and leases parking spaces to local companies?
The answer will hinge on whether the IRS considers activity-generating income from the property a “trade or business.” Without that designation, practitioners told Bloomberg Tax, it won’t matter whether the individual or company counts as an excluded “specified service” business in the first place.
‘Trade or Business’ Spectrum
The 20 percent pass-through deduction, created by the 2017 tax act (Pub. L. No. 115-97) under new tax code Section 199A, is available—with many exceptions above set income thresholds, as listed in the IRS’ proposed rules (REG-107892-18; RIN:1545-BO71)—to a “trade or business” as described in tax code Section 162. Under that section, the taxpayer must be involved in the activity “with continuity and regularity” to reach the “trade or business” standard.
Real estate can involve a lot of activity from the business owner or take the form of a passive investment. Whether it counts as a trade or business has long been murky.
“Along the spectrum, you have to decide where each activity lands,” said Troy Lewis, who chairs the task force on qualified business income—the income eligible for the pass-through deduction—at the American Institute of CPAs. He told Bloomberg Tax that as of Aug. 13, he’d been asked “about a dozen times” whether residential rentals qualify for the new write-off.
By referencing Section 162 in the proposed rules, he added, “Treasury just sort of said, ‘This is hard. We’re going to use something that is already there.’ But what is already here isn’t clear.”
The IRS and Treasury didn’t respond immediately to requests for comment.
Individuals who use Airbnb or rent out their own properties and aren’t highly involved in its upkeep, for example, could be caught on the fence, practitioners said. The same dilemma arises for companies organized as pass-throughs that own an office building, but rent out floors or parking areas to other businesses—something Steven Schneider, a partner at Baker McKenzie LLP in Washington who specializes in real estate, described as “cheaper capital for a big company.”
Individuals using a “triple net lease,” in which the lessor doesn’t meaningfully participate in the building’s operations or management, could face difficulty, or at least uncertainty, in determining whether their rental income comes from active or passive activity, Schneider said. That’s in part because “the ‘trade or business’ test is a facts and circumstances one,” he added.
“Your downtown New York City buildings that have lobbies—that’s a trade or business,” he said. “It’s a fair question to ask” the IRS and Treasury Department “to clarify it with some sort of example for a regular guy: Is triple net lease in it or not? I think they could give some more guidance, particularly for the small guy that owns a rental property on the side.”
Requests Unanswered, Guidance Unlikely
The AICPA, in a February letter, asked the IRS to clarify that real estate professionals who rent their property, as defined in a code another section that distinguishes between passive and active business activities, generate qualified business income—rendering it eligible for the new pass-through deduction.
IRS guidance should also name “any specific circumstances in which other real estate activities” wouldn’t generate that income, thereby excluding them from the 20 percent write-off, according to the letter, written by Lewis’ task force.
The government did neither, Lewis said.
Practitioners largely don’t expect additional guidance on this issue—nor lobbying, for that matter—in the future.
Glenn Dance, a managing director in the partnership tax group at Grant Thornton LLP in Washington and a former IRS official, said it’s “unlikely” that the IRS will, “of its own initiative,” draw a bright line between eligible and ineligible real estate income. He maintained, however, that the issue “is something we’re going to need guidance on,” because “the world is full of people” renting out former, secondary, vacation, or other homes—through home-sharing apps or otherwise.
“It’s going to be mostly the moms and pops of the world who rent out their houses, and the Airbnb folks, and that crowd is not represented by the real estate lobbyists in D.C.,” Dance said. “There’s a lot of need for clarity there.”