Monday, April 22, 2019
Last week’s post on the self-rental rule of Treas. Reg. §1.469-2T(f)(6) generated a lot of interest. As noted in that post, the self-rental rule bars a taxpayer with passive losses from artificially creating passive income from another activity to offset the passive losses. One way to potentially do this is to self-rent property. Questions were raised as to the rule’s application to S corporations. In addition, there were additional questions raised as to how the rule applied with respect to the net investment income tax (NIIT) of I.R.C. §1411 and whether self-rentals are eligible for a qualified business income deduction (QBID) under I.R.C. §199A.
Digging a bit deeper on the self-rental rule – it’s the topic of today’s post.
In general. In prior posts last year and earlier this year, I wrote on the various aspects of the QBID. The QBID was created under the Tax Cuts and Jobs Act and is effective for tax years beginning after 2017 and before 2026. The QBID is a 20 percent deduction for noncorporate taxpayers against qualified business income (QBI). QBI is the net amount of items of income, gain, deduction and loss with respect to a trade or business. A qualified trade or business is any trade or business other than a specified service trade or business (SSTB) or the business of performing services as an employee. An SSTB is a trade or business involving performance of services in the field of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees. Taxpayers who own an SSTB may still qualify for the deduction if a taxpayer’s taxable income (for 2019) does not exceed $321,400 for a married couple filing a joint return, or $160,700 for all other taxpayers except that married filing separate taxpayers have a $160,725 threshold.
Rental activities. To be eligible for the QBID, a rental activity must rise to the level of trade or business in accordance with I.R.C. §162. That is a different (and more stringent) standard than that utilized for purposes of the passive loss rules of I.R.C. §469, and it requires regularity and continuity in the activity. There are many decided cases involving the issue of whether a trade or business exists under the I.R.C. §162 standard with the courts utilizing numerous factors such as the type and number of properties rented; how involved the taxpayer is in the business; whether any ancillary services are provided under the lease and, if so, the type; and, the type of the lease. These factors are also listed in the preamble to the I.R.C. §1411 regulations.
In August of 2018 QBID proposed regulations were released. The proposed regulations defined “self-rentals” as a “trade or business.” Thus, the income from a self-rental will qualify for the QBID if the self-rental is being leased through a passthrough business that is under “common control.” Common control is necessary to combine rentals with other business activities and is defined when the same person or group, directly or indirectly own 50% or more of each trade or business.
Seth Poole is the sole owner of an S corporation that is engaged in manufacturing widgets. Seth also owns an office building that he holds in his single member limited liability company (LLC). The LLC leases the office building to the S corporation under a triple-net lease (a lease agreement where the lessee agrees to pay all real estate taxes, building insurance, and maintenance on the property in addition to any normal fees such as rent, utilities, etc.). Because the office building is leased between entities that are under common control, and the S corporation is carrying on a trade or business, the triple-net lease activity qualifies as eligible for the QBID.
The “takeaway” from the proposed regulations was that self-rentals between entities that are under common control can produce a significant QBID.
In mid-January of 2018, the Treasury released the QBID final regulations. Issued along with those final regulations was Notice 2019-07 providing safe harbor rules for rental activities on the trade or business issue. In essence, to qualify for the safe harbor, a rental real estate activity is a QBI-qualifying trade or business under I.R.C. §199A if the taxpayer provides at least 250 hours of services during the tax year. But, it is important to remember that the safe-harbor is just that – a safe-harbor. A rental activity can qualify as an I.R.C. §162 trade or business without meeting the safe harbor requirements if the facts and circumstances support such a finding.
Under the final regulations, a self-rental constitutes an I.R.C. §162 trade or business for QBID purposes if the rental involves commonly controlled entities (either directly or via attribution under I.R.C. §§267(b) or 707(b)) where the self-rental income is not received from a C corporation. The final regulations also bar taxpayers from shifting SSTB income to non-SSTB status by using a self-rental activity where property or services are provided to an SSTB by a trade or business with common ownership. Under the rule, a portion of the trade or business that provides property to the commonly owned SSTB is treated as part of the SSTB with respect to the related parties if there is at least 50 percent common ownership.
A group of CPAs own a building. They lease 80 percent of the building space to the CPA firm and 20 percent of the building to an unrelated chiropractor. The 20 percent would be classified as non-SSTB income while the 80 percent would be treated as SSTB income. The general rule is that a rental real estate trade or business is not treated as an SSTB, subject to the taxable income limitations. However, that rule changes if there is common ownership exceeding 50 percent. If there is, the rental income attributable to the commonly controlled SSTB is treated as if it were SSTB income.
Even though the passive loss rules of I.R.C. §469 don’t specify that they apply to S corporations, the Tax Court has held that the self-rental rule applies to rentals by S corporations. In Williams v. Comr., T.C. Memo. 2015-76, the taxpayers (a married couple) owned 100 percent of an S corporation and 100 percent of a C corporation. The husband worked full-time for the C corporation during 2009 and 2010, and materially participated in its activities. Neither of the taxpayers materially participated in the S corporation or the rental of commercial real estate to C corporation. They also were not engaged in a real estate trade or business. In 2009 and 2010, the S corporation leased commercial real estate to the C corporation so that the C corporation could use it in its business. For those years, the S corporation had net rental income that the taxpayers reported as passive income on Schedule E which they then offset with passive losses. The IRS disagreed and recharacterized the rental income as non-passive under the self-rental rule.
In upholding the IRS position, the Tax Court determined that passthrough entities are subject to I.R.C. §469 (which included the taxpayers’ S corporation) even though not specifically mentioned by the statute. They did not need to be mentioned, the Tax Court reasoned, because they were not taxpayers. The Tax Court also rejected the taxpayers’ argument that the self-rental rule didn’t apply because the S corporation did not participate in the C corporation’s trade or business. It was enough that the husband personally provided material participation in the C corporation’s business to trigger the application of the self-rental rule. The rental income from the lease was non-passive.
The 3.8 percent NIIT applies to taxpayer’s with passive income that exceeds $250,000 on a joint return ($125,000 married filing separately; $200,000 for other filing statuses). Generally, the passive loss rules apply in determining whether an I.R.C. §162 trade or business is passive for NIIT purposes. Thus, if a taxpayer has rental income from an activity in which the taxpayer materially participates, the NIIT will not apply. But, what about the self-rental recharacterization rule? Treas. Reg. §1.1411-5(b)(2) specifies that, “To the extent that any income or gain from a trade or business is recharacterized as “not from a passive activity” by reason of . . . §1.469-2(f)(6), such trade or business does not constitute a passive activity . . . with respect to such recharacterized income or gain.”
Thus, if the self-rental recharacterization rule applies, it will cause the trade or business at issue to not be passive for NIIT purposes only with respect to the recharacterized income or gain. Treas. Reg. §1.1411-5(b)(2)(iii). When gross rental income is treated as not being derived from a passive activity because of a grouping a rental activity with a trade or business activity, the gross rental income is deemed to be derived in the ordinary course of a trade or business. Thus, the NIIT would not apply. Treas. Reg. §1.1411-4(g)(6)(i).
For purposes of the NIIT, the self-rental rule is applied on a person-by-person basis. Thus, there can be situations involving multiple owners in a rental entity where some will be subject to the NIIT and others who will not be subject to the NIIT based on individual levels of participation in the activity.
The self-rental rules involve numerous traps for the unwary. For taxpayers with such scenarios, seeking competent tax counsel is a must.