It can be difficult to determine whether renting real estate rises to the level of a Section 162 trade or business. Because this is a facts and circumstances test, many court cases, before and after Groetzinger (the Supreme Court decision stating that, to be engaged in a trade or business, a taxpayer must be involved in the activity with continuity and regularity and the primary purpose for engaging in the activity must be for income or profit) have addressed whether the rental of real estate is a trade or business. Therefore, a review of some of these cases helps get a sense of the factors the courts have considered when making this determination.
Factors considered for determining whether rental real estate activities are sufficient, continuous, and substantial enough to constitute a trade or business include the following (Keefe):
1. The taxpayer's efforts to rent the property.
2. The maintenance and repairs supplied by the taxpayer (or an agent of the taxpayer).
3. The taxpayer's employment of labor to manage the property or provide services to tenants.
4. The purchase of materials, the payment of expenses, and the collection of rent.
Taxpayers who use an agent to conduct the activities can still be considered to be engaged in a trade or business (Gilford).
Observation: Most of the court cases discussed here involve properties sold at a loss. In that case, taxpayers who successfully argue that they are engaged in a trade or business can generally take an ordinary (rather than a capital) loss. If the property is held over 12 months and sold at a gain, the gain is usually taxed at the long-term capital gain rate regardless of whether the property is a capital asset or one used in a trade or business. Now that the qualified business income (QBI) deduction relies on the Section 162 definition of a trade or business, it is likely that more cases will be heard.
Rental Activity Held to Be a Trade or Business
In the following cases, the courts 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 (1) the acquisition of the property was involuntary, (2) the operation of the property was not intended to be of long duration, (3) only a small part of decedent's income was derived from the rental of real estate, and (4) 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 or 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 Troy, 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.
Caution: In the preamble to the final regulations, the IRS noted that, when determining whether a rental real estate activity rises to the level of a Section 162 trade or business, it will consider whether taxpayers are consistent in their reporting. For example, the IRS will scrutinize a situation where taxpayers who own tenancy in common interests in rental property treat such interests as a trade or business for the QBI deduction but do not treat the joint venture as a partnership for tax purposes. Likewise, the failure to file Forms 1099-MISC for a rental real estate activity that is treated as a business for the QBI deduction may raise a flag.
Rental Real Estate Safe Harbor
Rev. Proc. 2019-38 provides a safe harbor for determining when a rental real estate enterprise may be treated as a trade or business for purposes of IRC Sec. 199A.
A rental real estate enterprise is defined as an interest in real property held for the production of rents and may consist of an interest in a single property or interests in multiple properties. A taxpayer or RPE relying on the safe harbor must hold the interest directly or through a disregarded entity. Taxpayers must either treat each property held for the production of rents as a separate enterprise or treat all similar properties held for the production of rents as a single enterprise. Commercial and residential real estate may not be part of the same enterprise. Once a taxpayer has chosen to treat all similar interests as a single enterprise, they must apply this treatment consistently from year to year, including any newly acquired properties, as long as the taxpayer continues to rely on the safe harbor. If the taxpayer originally treats all interests as separate enterprises, the taxpayer may choose to combine the properties into a single enterprise in a future year. Mixed-use property (a single building that combines residential and commercial units) may be treated as a single enterprise or may be divided into separate residential and commercial interests. If treated as a single enterprise, mixed-use property may not be combined with any other property.
The following types of property are not eligible for the safe harbor:
• Triple net leased property [an arrangement where the tenant pays taxes, fees, insurance, and maintenance costs (or a portion thereof) related to the leased property],
• Property used by the taxpayer (including an owner or beneficiary of an RPE) as a residence (under the Section 280A rules) for any part of the year,
• Real estate rented to a trade or business conducted by a taxpayer or an RPE that is commonly controlled, and
• The entire rental real estate interest if any portion of the interest is treated as an SSTB.
Under the safe harbor (and solely for purposes of IRC Sec. 199A), a rental real estate enterprise will be treated as a trade or business if the following requirements are met during the tax year:
1. Separate books and records (and presumably separate bank accounts) must be maintained for each rental real estate enterprise. If a rental real estate enterprise contains more than one property, this requirement may be satisfied if income and expense statements for each property are maintained and then consolidated.
2. For rental real estate enterprises that have been in existence less than four years, at least 250 hours of rental services (defined later in this discussion) are performed each tax year with respect to the rental enterprise. For rental real estate enterprises that have been in existence for at least four years, in any three of the five consecutive tax years that end with the tax year (or in each year for an enterprise held for less than five years), 250 or more hours of rental services are performed per year with respect to the rental real estate enterprise.
3. The taxpayer maintains, and has available for inspection upon request, contemporaneous records, including time reports, logs, or similar documents, regarding the following:
a. hours of all services performed,
b. description of all services performed,
c. dates on which such services were performed, and
d. who performed the services.
4. A statement must be attached to a timely filed original return (or an amended return for the 2018 tax year only) for each tax year in which the taxpayer or RPE relies on the safe harbor. Taxpayers or RPEs with more than one rental real estate enterprise may submit a single statement, however, information must be provided separately for each enterprise. The statement must include:
• A description (including the address and rental category) for all properties that are included in a single rental real estate enterprise;
• A description (including the address and rental category) for properties acquired or disposed of in the tax year; and
• A representation that the requirements of Rev. Proc. 2019-38 have been met.
Note: The contemporaneous records requirement will not apply to tax years beginning before 2020.
Note: Failure to meet the safe harbor does not preclude treatment of a real estate enterprise as a trade or business for the QBI rules. Enterprises that do not meet the safe harbor requirements may still be treated as a trade or business for Section 199A purposes if they otherwise can meet the definition of a Section 162 trade or business.
Rental services may be performed by owners, employees, and independent contractors and include (1) advertising to rent or lease the real estate; (2) negotiating and executing leases; (3) verifying information contained in prospective tenant applications; (4) collecting rent; (5) daily operation, maintenance, and repair of the property, including the purchase of materials and supplies; (6) managing real estate; (7) purchasing materials; and (8) supervising employees and independent contractors.
Caution: Various administrative duties such as time spent arranging financing; procuring property; reviewing financial statements or reports on operations; planning, managing, or constructing long-term capital improvements; and traveling to and from the real estate cannot be included in the 250 hours of service.
Special Rule for Self-rentals
The rental or licensing of property (tangible or intangible) that does not rise to the level of a Section 162 trade or business is still treated as a trade or business for the QBI rules if the property is rented or licensed to a trade or business conducted by the taxpayer or RPE that has 50% or more common ownership (considering indirect ownership), even if the rental/licensing activity would not otherwise qualify for aggregation [Reg. 1.199A-1(b)(14)]. For this rule to apply, the same person or group of persons must own [directly or indirectly under the attribution rules of IRC Sec. 267(b) and 707(b)] 50% or more of the rental activity and the Section 162 trade or business [Reg. 1.199A-4(b)(1)(i)].
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