The IRS, in its new proposed Section 199A regulations, defines when a rental property qualifies for the 20 percent tax deduction under new tax code Section 199A. One part of the good news on this clarification is that it does not require that we learn any new regulations or rules. Existing rules govern. The existing rules require that you know when your rental is a tax law–defined rental business and when it is not. For the new 20 percent tax deduction under Section 199A, you want rentals that the tax law deems businesses.
You may find the idea of a rental property as a business strange because you report the rental on Schedule E of your Form 1040. But you will be happy to know that Schedule E rentals are often businesses for purposes of not only the Section 199A tax deduction but also additional tax code sections, giving you even juicier tax benefits.
Under the proposed regulations, you have two ways for the IRS to treat your rental activity as a business for the Section 199A deduction:
- the rental property qualifies as a trade or business under tax code Section 162, or
- you rent the property to a “commonly controlled” trade or business.
Your rental qualifying as a Section 162 trade or business gets you other important tax benefits:
- Tax-favored Section 1231 treatment
- Business use of an office in your home (and, if it’s treated as a principal office, related business deductions for traveling to and from your rental properties)
- Business (versus investment) treatment of meetings, seminars, and conventions
Trade or Business Route
Although reported on Schedule E of your Form 1040, most rental activities will qualify as Section 162 trade or business activities. Unfortunately, there’s no black and white test: you have to look at case law and make a judgment call.
Hazard Case
The Hazard case shows how easy it can be for you to qualify your rental as a business. In this precedent-setting case, Mr. Hazard moved to Pittsburgh for new employment and listed his former Kansas City residence for sale or rent. He rented the house for about three years, after which he sold the property at a loss. The Tax Court determined that Mr. Hazard used the property in a trade or business even though the court record has no mention of management activities by the taxpayer
Levy Case
In Levy, the court ruled that the trustees of this estate, by renting the real estate, were engaged in a trade or business. The court then went on to say this:
Courts have consistently held that 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. It has been held that a taxpayer who rents only a single parcel of real estate is engaged in the “trade or business” of renting real estate if his activities are regular and continuous. The fact that the trustees employed agents to manage the real property does not make any difference.
Cottle Case
In Cottle, the Tax Court ruled that Mr. Cottle bought three fourplexes in what was, for him, a new trade or business of renting apartments.
Jephson Case
In Jephson, the court ruled that Mr. Jephson had a business when he bought a house to rent, listed it for rent, and showed it to prospective tenants but never rented it.
Key Point
If you have regular and continuous involvement with your rental activities, then you’ll meet the Section 162 trade or business test and qualify for the 20 percent Section 199A deduction on the rental activity.
The “Commonly Controlled” Route
If your rental activity doesn’t qualify as a Section 162 trade or business, it will qualify for the 20 percent Section 199A tax deduction if you rent it to a commonly controlled trade or business.
For purposes of this rule, “commonly controlled” means the same person or group of persons, directly or indirectly, owns 50 percent or more of each trade or business. The law attributes any interest in a trade or business owned by your spouse, children, grandchildren, and parents to you as well.
Final Thought
In its proposed regulations, the IRS gives us pretty much all we need to determine whether a rental property qualifies for the 20 percent Section 199A tax deduction.
The Section 162 trade or business test, even though it is based on facts and circumstances, means your rental activities likely qualify for the Section 199A tax deduction as long as you have regular and continuous involvement with them.
And if your rental isn’t a Section 162 trade or business, but you or your spouse rent the property to one of your commonly controlled trades or businesses, that rental qualifies as a Section 199A rental.