Rental Activities and the §199A Qualified Business Income Deduction
The §199A deduction is a commonly missed opportunity for rental activities
The One Big Beautiful Bill Act (OB3 Act) made the §199A deduction permanent. A key source of confusion among tax practitioners since the enactment of §199A was the eligibility of a rental activity for the deduction.
The IRS attempted to resolve the issue by issuing a §199A eligibility safe harbor; however, it was poorly designed and overly complex, further adding to the confusion. As a reminder, a safe harbor in the tax law is not a requirement to claim a tax benefit; it is a bright-line shortcut to apply a vague or subjective standard.
Missing the §199A deduction for rental activities remains a frequent error on returns that I review, so it is important to explain how to make this determination.
When Does a Rental Activity Qualify for the §199A Deduction?
Under Treas. Reg. §1.199A-1(b)(14), a rental activity qualifies for the §199A deduction in one of two ways:
It is a §162 trade or business, or
A commonly controlled trade or business is the lessee.
§162 Trade or Business
In Commissioner v. Groetzinger, 480 U.S. 23 (1987), the Supreme Court said that for an activity to be a trade or business:
…the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit. A sporadic activity, a hobby, or an amusement diversion does not qualify.
In Higgins v. Commissioner, 312 U.S. 212 (1941), the Supreme Court said that the trade or business determination is dependent on the facts and circumstances of that taxpayer’s particular situation, which can make many tax professionals uncomfortable since it is not a bright-line test or standard.
In Service Center Advice 200120037, the IRS opined that most rental activities qualify as §162 trade or business activities, citing cases over the last 70 years:
Where it is clear from the facts that real estate is devoted to rental purposes, the courts have repeatedly held that such use constitutes use of property in a trade or business, regardless of whether or not it is the only property so used...
For example, in Hazard v. Commissioner, 7 T.C. 372 (1946), the Tax Court determined that the rental of a single residential property constituted a trade or business, even though the record contained no information about the owner's activity level.
The IRS acquiesced to the Hazard decision and has not changed its position that minimal activity is needed, as stated in General Counsel Memorandum 38779:
...the problem that you raise is not with the legal standard applied by the courts, but with the relatively small amount of activity that the courts have found to be indicative of a trade or business. In view of the number of cases that have been decided on this issue, only some of which have been cited above, it is unlikely that the Service could now persuade the courts to take a more restrictive approach with respect to the amount of activity required to find that a taxpayer’s rental activity constituted a trade or business.
The preamble to the final §199A regulations provided factors to consider when determining if a rental activity rises to a §162 trade or business:
Type of rented property (commercial real property versus residential property)
Number of properties rented
The owner’s or the owner’s agent’s day-to-day involvement
Types and significance of any ancillary services provided under the lease
Terms of the lease (a net lease versus a traditional lease, and a short-term lease versus a long-term lease)
Examples of a rental activity that would typically not constitute a §162 trade or business:
A single triple-net lease; however, it is possible that the rental of a triple-net lease property in conjunction with other rental activities could cause all of the rental activities to collectively rise to the level of a §162 trade or business. See Lewenhaupt v. Commissioner, 20 T.C. 151 (1953); CRSO v. Commissioner, 128 T.C. 153 (2007).
A rental not engaged in for profit, considering the §183 regulations. For example, a significantly below-market rental amount to a family or friend, or a lease-back to the original owner of a residence as part of the sale of that residence.
Whether or not a rental activity is passive under §469 is not determinative of its §162 trade or business determination. A rental activity (or even a non-rental activity, such as ownership of a pass-through entity as a mere investor) can be both a passive activity and a §162 trade or business.
Rental Activity Safe Harbor
In September 2019, the IRS issued Rev. Proc. 2019-38 to provide a safe harbor for §199A determinations for rental activities; however, it is very restrictive and disadvantages small-scale rental property owners. As the safe harbor itself says:
If an enterprise fails to satisfy the requirements of this safe harbor, it may be treated as a trade or business for purposes of section 199A if the enterprise otherwise meets the definition of trade or business…
To meet the safe harbor, a taxpayer must demonstrate at least 250 hours of rental services across the “rental real estate enterprise” by owners, employees, agents, and/or independent contractors. There are complex rules on how to assemble one’s rental real estate enterprise(s), and the taxpayer must document hours, including those of their workers, to meet the safe harbor.
To reiterate: the safe harbor is optional. A rental activity that is a §162 trade or business qualifies for the §199A deduction regardless of the 250-hour rule.
Commonly Controlled Trade or Business Rental
A rental activity can fail to be a §162 trade or business and yet qualify for the §199A deduction if the taxpayer rents the property to a commonly controlled trade or business. Common control exists when the same person or group of persons, directly or by attribution under §267(b) or §707(b), owns 50% or more of both the rental activity and the §199A-eligible trade or business. See Treas. Reg. §1.199A-4(b)(1)(i).
If a rental activity qualifies for the §199A deduction under this provision, and the commonly controlled business is a specified service trade or business (SSTB), then that portion of the rental property being rented to the 50% or more commonly-owned SSTB is treated as a separate SSTB with respect to the related parties. See Treas. Reg. §1.199A-5(c)(2)(i).