Despite Guidance, Lots of Questions Remain Regarding Rental Income
Treasury and the IRS released IRC § 199A proposed regulations, REG-107892-18, on August 8, 2018. These are proposed regulations, but taxpayers can rely on them until final rules are adopted. The proposed regulations define “trade or business” as an IRC § 162 trade or business (other than the trade or business of performing services as an employee). (Proposed § 1.199A-1(b)(13)). They do not provide bright-line standards or a safe harbor regarding this definition. This leaves many questions unanswered regarding what rental income will qualify for the 199A deduction. And this question impacts many in farm country. In Iowa, for example, 53 percent of Iowa farmland was leased in 2017, with the majority of these leases being cash rent leases. This post reviews the status of current law and addresses the gray that remains.
Section 199A requires that qualified business income eligible for the 199A deduction must come from a “qualified trade or business.” The proposed regulations state that for purposes of 199A, IRC § 162(a) provides the most appropriate definition of “trade or business.” IRS notes that the definition is “derived from a large body of existing case law and administrative guidance interpreting the meaning of trade or business in the context of a broad range of industries.” IRS states, “Defining trade or business as a section 162 trade or business will reduce compliance costs, burden, and administrative complexity.” Solely for purposes of IRC § 199A, the regulations do provide that the rental of property to a related trade or business is automatically treated as a trade or business if the rental and the other trade or business are commonly controlled (regardless of whether the rental activity and the trade or business are otherwise eligible to be aggregated under § 1.199A-4(b)(1)). This provision will be discussed in more detail in another post. But for all other rentals, a fact-based determination must be made as to whether the rental is a "trade or business" before the 199A deduction may be claimed.
There is no bright-line definition of what types of rental activities constitute trades or businesses for purposes of IRC § 162. The courts make trade or business determinations on a case-by-case basis after a highly factual inquiry.
The best “definition” for an IRC § 162 “trade or business” is the most recent guideline from the U.S. Supreme Court: To be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity. Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987). A sporadic activity, a hobby, or an amusement diversion does not qualify. Id. Even in issuing the standard, the Groetzinger court noted its difficulty:We therefore adhere to the general position of the Higgins Court, taken 46 years ago, that resolution of this issue "requires an examination of the facts in each case." This may be thought by some to be a less-than-satisfactory solution, for facts vary. But the difficulty rests in the Code's wide utilization in various contexts of the term "trade or business," in the absence of an all-purpose definition by statute or regulation, and in our concern that an attempt judicially to formulate and impose a test for all situations would be counterproductive, unhelpful, and even somewhat precarious for the overall integrity of the Code. We leave repair or revision, if any be needed, which we doubt, to the Congress where we feel, at this late date, the ultimate responsibility rests.
The Question Hasn't Mattered Much for Most Rentals
IRC §1402(a)(1) generally excludes rental income from the definition of net earnings from self-employment. Additionally, IRC § 212 allows taxpayers to deduct expenses associated with rental activities that do not rise to the level of a trade or business under IRC § 162. Ordinary and necessary expenses for a rental property that is a trade or business are deductible under both § 212 and § 162. Curphey v. Commissioner, 73 T.C. 766, 773 (1980). Consequently, the question of whether a rental is a section 162 trade or business has not been litigated enough to have a clear, consistent framework of judicial interpretation. Most modern cases exploring whether a rental activity is a trade or business address whether the taxpayer can take the home office deduction under IRC § 280A (which uses the IRC § 162 standard) or whether the sale of a rental property is the sale of a capital asset under IRC § 1221 or a trade or business asset under IRC § 1231. Because the sale of rented farm property, for example, rarely results in a loss, reporting the sale on Form 4797 or Schedule D has often been a distinction without a difference. Cases predating IRC § 212’s predecessor IRC § 23(a)(2) nearly all granted trade or business status to taxpayers with rental property because to deny that status was to deny any deduction. Even after the broader deduction was allowed for property held for investment, the majority of courts continued to find that renting even a single property can rise to the level of a trade or business.
The Net Investment Income Tax Regulations Weighed In
In its final regulations for the net investment income tax, TD 9644 (2013), IRS acknowledged difficulties with respect to applying the trade or business standard to rental property:The Treasury Department and the IRS received multiple comments regarding the determination of a trade or business within the context of rental real estate. Specifically, commentators stated that Example 1 of proposed §1.1411–5(b)(2) is inconsistent with existing case law regarding the definition of a trade or business of rental real estate. Commentators cited cases such as Fackler v. Commissioner, 45 BTA 708 (1941), aff’d, 133 F.2d 509 (6th Cir. 1943); Hazard v. Commissioner, 7 T.C. 372 (1946); and Lagreide v. Commissioner, 23 T.C. 508 (1954), for the proposition that the activities of a single property can rise to the level of a trade or business. The Treasury Department and the IRS agree with commentators that, in certain circumstances, the rental of a single property may require regular and continuous involvement such that the rental activity is a trade or business within the meaning of section 162. However, the Treasury Department and the IRS do not believe that the rental of a single piece of property rises to the level of a trade or business in every case as a matter of law… Within the scope of a section 162 determination regarding a rental activity, key factual elements that may be relevant include, but are not limited to, the type of property (commercial real property versus a residential condominium versus personal property), the number of properties rented, the day-to-day involvement of the owner or its agent, and the type of rental (for example, a net lease versus a traditional lease, short-term versus long-term lease). Therefore, due to the large number of factual combinations that exist in determining whether a rental activity rises to the level of a section 162 trade or business, bright-line definitions are impractical and would be imprecise.
This hasn't been a widespread question in the net investment income context because the question of whether a rental property is a trade or business is only relevant if the property is rented by a real estate professional. Net investment income applies to most rental activities, even if they are an IRC § 162 trade or business because rental activity not conducted by a real estate professional is generally deemed by statute to be passive (self-rentals being one exception). IRC § 1411(c)(2)(A).
What Constitutes the Trade or Business of Real Estate Rental?
The IRS once tried to argue that the management of real property and the management of securities is similar and should be treated the same. But, courts have long recognized that the distinction between ownership and management of real property and of securities is significant in determining what constitutes a "trade or business." See Curphey, 73 T.C. at 774; Rogers v. United States, 69 F. Supp. 8, 12 (D. Conn. 1946). “In the final analysis, the issue is ultimately one of fact in which the scope of the ownership and management activities may be an important consideration.” The activities must be sufficiently systematic and continuous to “place the owner in the business of real estate rental.” Id.
The standard is not “material participation,” but conducting the rental activity with “continuity and regularity,” and for the primary purpose of profit. There is no bright-line hour requirement, and the question is highly factual. In the context of cash rent farmland rentals, the question is not whether the landlord is a materially participating farmer[i], but whether the activities of the landlord in managing his or her rental properties are sufficiently continuous and regular. For this purpose, activities conducted by a paid agent are attributed to the owner. See, e.g. Schwarcz, 24 T.C. 733, 739 (1955), acq., 1956-1 C.B. 5. ( The fact that the taxpayer operates the rental property through an agent does not prevent him from being regularly engaged in the business.). This fact-intensive determination is made on a case-by-case basis.
Example 1 on page 119 of the proposed regulations suggests that the rental of bare land can rise to the level of a trade or business. The example depicts an individual owning several parcels of land and leasing them to several suburban airports for parking lots. It is assumed in the example that the rental is a trade or business, even though the rental includes no depreciable property. It is the management of the parcels that is the trade or business. In this example, the landowner is ineligible for the deduction because his income is above the threshold, he pays no W-2 wages, and he has no qualified property.
The few published cases involving farm-related rentals have not provided clear analytical guidelines. In two cases below where trade or business status was not found, the taxpayer had little or no involvement with the rental property. There was no proof that the tenant did more than collect a check.
- Good v. Commissioner, 16 TC 906 (1951), acq., 1951-2 C.B. (20-acre pasture rental was trade or business of the taxpayer, not a capital asset; taxpayer owned 310 acres of additional farm property.)
- Anderson v. Commissioner, TC Memo 1982-576 (Nurse-anesthetist who tried to claim §280A home office deduction first for medical work and, alternatively for 80-acre farmland rental, was denied. Did not prove rental was a trade or business. “Petitioner testified in vague generalities about using his home office to pay bills, to store records, and occasionally to talk to his tenant on the telephone, but his testimony does not establish that his activities were sufficiently regular, systematic, and continuous as to place him in the business of farm management.” “One of the key factors is the scope and extent of the taxpayer's ownership and the management activities.”)
- Durbin v. Birmingham, 92 F. Supp. 938 (S.D. Iowa 1950)(Iowa banker owned land in Colorado. Leased from 1908 to 1942 to various individuals on a crop sharing contract, with no personal control or management exercised on the part of Mr. Durbin over such farming operations. Received “small amounts of income” from land. No deductions were taken. Land ultimately sold at a loss for unpaid taxes (while banker was alive). IRS said trade or business/ordinary loss, but widow prevailed in argument that it was capital asset held for the production of income.)
- Meinhardt v. Commissioner, 766 F.3d 917 (8th Cir. 2014) (Taxpayers owned 420 acres of farmland and a farmhouse. They cash rented the farmland, but did not lease the old farmhouse. Instead, they improved the house and allowed family members to live in the house from time-to-time, in exchange for services. Court denied an IRC § 162 deduction related to the farmhouse because the taxpayers "treated the farmhouse separately from the leased farmland, which was admittedly a business activity, and therefore expenses related solely to the farmhouse could not be deducted as ordinary and necessary expenses of the leased farmland activity." )
IRS Written Determinations
Several IRS written determinations have addressed the broader question.
- PLR 8350008 (Net lease at issue was 99-year lease of commercial building where owner merely received rental payment. Lessee was responsible for all taxes, maintenance, and liability. IRS said that the mere rental of real property does not constitute a trade or business under section 1231.)
- FSA 200120036 (Taxpayer leased building to his own corporation with continuity and regularity, and the taxpayer’s primary purpose for engaging in the rental activity was for profit. Accordingly, the rental activity was a trade or business, and the rentals were derived in the ordinary course of a trade or business.)
Given the above status of the law, in light of the proposed regulations, whether a farm rental activity is a trade or business will not always be clear. Several examples can be considered. Suggested answers are proposed, although the proposed regulations could change, and interpretations could vary.
Landowner A, who lives in Arizona, leases 80 acres of inherited Iowa farmland to a single tenant for a ten-year term. She collects the rent, but has little or no other contact with the tenant. She owns no other real property.
Under this bare fact pattern, Landowner A would likely not be involved in a trade or business so as to qualify for the IRC 199A deduction. This would likely be true even though the landlord paid the taxes and/or insurance on the property. Under the IRC § 162 standard, the limited activities of this landlord do not seem to be engaged in “with sufficient continuity and regularity” to rise to the level of a trade or business. Rather, they are more akin to investment-related activities.
Landowner B, owns 1,800 acres of farmland, which she rents out to three different tenants for one-year lease terms under fixed rent leases. Each lease is terminated and renegotiated each year, and each lease requires the tenant to report yields, soil fertility, and conservation practices, which the landlord closely monitors. The landlord is responsible for repairing drain tile, fences, and outbuildings. She works closely with her tenants to ensure farming practices that best preserve the health and sustainability of the farmland. She meets with her tenants regularly throughout the year.
A good argument can be made that Landowner B’s activities are sufficiently continuous and regular so as to qualify her as being in the trade or business of renting property, so as to qualify for the 199A deduction. Documentation of this activity is important to establish eligibility for the deduction.
Landowner C has the same facts as Landowner B, except that he hires a farm manager to manage his farm rental business.
Landowner C should be in the same position as Landowner B because the law allows business owners to count the activity of their agents in determining whether their activity rises to the level of being a trade or business.
Landowner D is a non-farmer with 120 acres enrolled in CRP.
IRS’ non-acquiescence to Morehouse means that Landowner D’s CRP income should qualify for the 20 percent deduction, even though he is a non-farmer. IRB No. 2015-41 (2015). The Tax Court’s position in Morehouse was that the non-farmer was in the trade or business of “participating in the CRP.” The Eighth Circuit removed the trade or business question by deeming the CRP payments to be “rent.” Morehouse v. Commissioner, 769 F.3d 616 (8th Cir. 2014), rev'g 140 T.C. 350 (2013). The IRS did not agree with the Eighth Circuit and issued an Action on Decision in 2015 stating that it would continue to litigate its position, even with respect to taxpayers in the Eighth Circuit where payments were made after 2008. That is good news for non-farmers wanting to take the 199A deduction on these payments. But unless they are on social security or disability and enjoy a statutory exclusion, they should pay SE tax if they take a deduction to avoid taking an inconsistent position on this issue.
Landowner E is a crop share landlord who materially participates in a crop share arrangement.
Landowner E is in the trade or business of farming (not renting property) and will qualify for the 199A deduction.
Landowner F is a crop share landlord who does not materially participate in a crop share arrangement.
Landowner F’s eligibility for the deduction will depend upon whether his activities are sufficiently regular, systematic, and continuous to constitute a “trade or business.”
Landowner G receives a yearly rental payment from a wind tower that is housed on her property.
Landowner G would not be eligible for the 199A deduction for this payment because the landowner would have no related activity beyond receiving a check. This would not qualify for trade or business status.
The question of what rental income will qualify for the 199A deduction is a key issue that impacts many taxpayers. The 199A “qualified trade or business” requirement and the proposed regulations pointing taxpayers to IRC § 162 leave lots of gray area for taxpayers and their tax advisors to navigate. We will continue to monitor this issue and provide updates as they arise. Remember, these are proposed regulations. The final regulations could provide some clarity.
[i] IRC 1402(a)(1) imposes self-employment tax on farm rental income where the income is derived from an arrangement under which the owner must materially participate in the production of agricultural or horticultural commodities and the owner does materially participate. In such a case, the owner is in the trade or business of farming, not renting property.
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