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Law in the Marketplace: Obtaining Deductions on Rental Real Estate Income

Written by: John M. Cunningham

Published in the Concord Monitor (11/28/2020)

Thousands of New Hampshire people who have non-real estate full-time jobs also own real estate that they rent to tenants as a side business. If you are one of those people, you need to know the federal income tax rules you must follow in order to obtain federal income tax deductions under Internal Revenue Code section 199A on your net rental income. As you may know, section 199A provides owners of “pass-through businesses” with remarkable and unprecedented deduction, which can amount to 20% of their shares of the net income of their business.

On Sept. 24, 2019, in an administrative ruling entitled Rev. Proc. 2019-38, the IRS published guidelines on how to obtain the above deduction on your rental real estate net income. These guidelines provide that you can obtain the deduction if, among other things:

-- You do not use triple net leases with your tenants;

-- You or your agents provide real estate rental services to your tenants for at least 250 hours during the relevant taxable year;

-- You keep extensive records concerning these services; and

-- You provide detailed statements about your rental real estate business in your federal tax return for that year.

The IRS definition of the term “triple net lease” is somewhat unclear. However, it seems to mean, in essence, real estate rental leases that require tenants to pay not only for rent and for utilities used in their properties but also real estate taxes and real estate insurance.

Obviously, most people who have full-time jobs but rent real estate to tenants as a side business can’t readily comply with the above guidelines; in particular, they can’t comply with the above “250-hour” guideline.

Fortunately, however, the IRS ruling also provides that the guidelines in it aren’t exclusive. In other words, you may be able to obtain a section 199A deduction on your net real estate rental income even if you don’t comply with any of them.

What guidelines, then, should you follow in order to claim a section 199A deduction on your net real estate rental income without a significant risk of an IRS audit? I suggest the five guidelines below. However, while I think the IRS will respect these guidelines, I obviously can’t guarantee this.

-- First, as noted, you shouldn’t use a triple-net lease with your tenants, since, if you do, the IRS may claim that your rental business is a mere passive investment and thus not a “trade or business,” as required by section 199A. Instead, your lease should provide, among other things, that if your tenants need real estate maintenance or repairs, they themselves can’t arrange for them. Instead, they must contact you, and you or your agents will provide them with these services promptly and for fair market charges.

-- Second, you must keep reasonably accurate records concerning the types of real estate rental services that you and your agents perform for your tenants and the number of hours you and they devote to on these services. The services may include, as noted, property maintenance and repairs, advertising of available rental properties, interviewing and approving potential new tenants, negotiating real estate rental leases with them, and periodic inspections of the properties they rent from you. But an IRS General Counsel’s Memorandum suggests that to be safe under section 199A, you should engage in relatively varied types of rental services in the relevant taxable year — say, three or more types.

-- Third, you must spend enough time on your rental real estate business to make it reasonably likely that this business will be profitable. However, if you have good tenants, one Tax Court case suggests that your rental real estate business will be a section 199A “trade or business” and thus will qualify for a deduction under that section even if you spend as little as two hours a month on it.

-- Fourth, a U.S. Supreme Court case suggests that you should engage in your real estate rental services “regularly and continuously.”

-- Fifth, you must not use any of your rental properties even occasionally as vacation properties for yourself and your family.

In short, to maximize the likelihood that the IRS will not challenge section 199A deductions you claim from your net real estate rental income, you need to do some careful planning, and you must provide your tenants, by yourself or through your agents, with a variety of real estate rental services. But in my view, if you follow the above five guidelines, you stand a very good chance of avoiding an IRS audit of your claim.

 

John Cunningham is a Concord, NH lawyer of counsel to McLane Middleton, P.A. His practice is focused on LLC formations, general business and tax law, advising clients under IRC section 199A, and estate planning. His telephone number is (603) 856-7172, his e-mail address is [email protected], and the link to his website is www.llc199A.com.

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