When tax reform was enacted a little more than 18 months ago, there were more questions than answers about how the new rules would apply to rental real estate. Some taxpayers courageously did the best they could to restructure their rentals to take advantage of the new law while others adopted a wait-and-see approach.
Over the last 20 months, the IRS has issued thousands of pages of notices and regulations and we now have a much clearer picture of how the new rules will apply. Regardless of your initial approach to tax reform, now is a great time to revisit the structure of your rental real estate activities to make sure you are taking full advantage of the $1.5 trillion in available tax savings.
Consider these three issues to maximize the tax benefits of your rental real estate:
- Whether the rental is classified as a business or investment for tax purposes.
- Whether business or investment classification of rental real estate is better in your particular circumstances.
- Whether changes can be made to your lease arrangements and rental operations to obtain more favorable tax treatment.
Is your rental real property a business or investment for tax purposes?
Rental real estate can be classified as either a business or an investment for tax purposes. A discussion of whether a rental constitutes a business for tax purposes is covered in a separate article, but here are a few of the factors that affect the determination:
- Number and type of properties held for rental
- Number of tenants
- Duration of leases
- Level of day-to-day involvement by landlord (including landlord’s employees and contractors)
- Type and significance of services provided by landlord
- In the case of the Section 199A 20 percent business income deduction, whether the tenant is a commonly-owned pass-through business — a self-rental rule automatically treats the rental as a business for purposes of the deduction
All other things being equal, the more you are involved in your rental activity, the more likely your rental activity will be considered a business. For example, a rental subject to a one-year lease is more likely to be considered a business than a rental subject to a 10-year lease because a short lease requires more involvement by you (or your property management company) to renegotiate the lease or identify a new tenant. Each situation is unique and you should consult with your tax advisor to consider how these factors apply to your rental activity.
Example of rental real estate structured as an investment
Adam owns one rental property, an industrial building subject to a 15-year triple net lease with a single tenant. Under the terms of the lease, the tenant covers all repairs, insurance, and taxes and even pays for a management company to oversee the property. The rent is a fixed amount which increases by 3 percent annually. Adam’s involvement is limited to collecting rent checks. The rental appears to be an investment for tax purposes because Adam (including Adam’s agents) is not involved in the rental activity on a regular and continuous basis.
Example of rental real estate structured as a business
Abigail owns an apartment complex with 200 units having lease terms ranging from month-to-month to 15 months. Abigail employs workers to lease apartments, maintain the property, collect rent, engage in eviction proceedings as necessary, and other activities. Abigail’s involvement (including that of her employees and agents) is regular and continuous and the rental appears to be a business.
Is business or investment status better for your rental real estate?
Once you have determined whether your rental is a business or an investment, you should consult with your CPA to consider whether that characterization provides the best tax result for you. The following table illustrates just a few of the implications of business and investment status.
|Item Affected by Classification of Rental Activity||Effect of Business Status (in General)|
|Section 199A — 20 percent deduction for certain pass-through business income||
|Business interest limitation||
|Gain from sale of rental property held more than a year||
|Loss from sale of rental property held more than a year||
|Excess business loss limitation||
In some cases, it will be clear which status is favorable in your situation. In other cases, there may be some items that are favorably affected by business status and others favorably affected by investment status. If there is no clear best approach, you may want to work with your CPA to model your after-tax cash flow operating your rentals as a business or as an investment.
Are you able to modify your rental operations to achieve a better tax result?
If you determine the current business or investment classification of your rental is not ideal, you should consider whether it is feasible to make changes to your rental activity to alter the classification and achieve a better tax result. Plan to stick with an approach for a number of years rather than flip-flopping status every time your preferred status changes.
Example of changing structure to investment status
Alex and Paul each own 50 percent of AP, Inc., an S corporation that conducts a manufacturing business. Alex and Paul also each own 50 percent of AP LLC, a partnership for tax purposes which owns a single asset, an industrial building rented exclusively to AP, Inc.
The lease is an annual agreement and requires AP, Inc. to provide daily janitorial services, weekly landscaping, monthly pest control, and other substantial services. AP LLC is profitable and generates substantial interest expense. AP LLC, in consultation with its CPA, determines that the rental activity is treated as a business for tax purposes and that investment status would be preferable: business status causes the deduction for interest expense to be limited and the rental would qualify for the 20 percent business income deduction either way under the 199A self-rental rule.
AP LLC restructures its lease with AP, Inc., reducing the rental rate and eliminating the services provided by AP LLC. Going forward, AP, Inc. will be responsible for all of the repairs, maintenance, taxes, and insurance associated with the property. As a result of the change, AP LLC will no longer be subject to the business interest limitation, increasing the amount of deductions available each year. AP LLC’s rental income continues to be eligible for the 20 percent business 199A deduction because of the self-rental rule.
Example of changing structure to business status
Jennifer and Keith each own 50 percent of Pacific Partnership. Pacific Partnership owns a single rental property, a manufacturing facility leased exclusively to a business with which Jennifer and Keith have no affiliation. The lease is a 15-year contract and the tenant is responsible for all repairs, maintenance, insurance, and taxes associated with the property. The property generates substantial rental income and is not subject to any debt. Pacific Partnership, in consultation with its CPA, determines that the rental activity is not a business but that business status would be preferable because it allows the rental income to qualify for the 20 percent business income deduction.
Pacific Partnership renegotiates the terms of its lease, obtaining additional rent in exchange for assuming the obligation to maintain the property and pay property taxes and insurance. In addition, Pacific Partnership agrees to provide daily janitorial services. The change enables the partnership to classify the rental as a business and obtain the associated tax benefits, which include the 20 percent 199A deduction.
How we can help
Determining whether a particular rental real estate activity constitutes a business for tax purposes has historically been an academic exercise, but that changed when tax reform added a 20 percent deduction for pass-through business income, a business interest limitation, and an excess business loss limitation, all of which are impacted by the business or investment status of rental real estate.
We can help you evaluate whether your rental activities constitute a business for tax purposes as currently structured and consider planning opportunities to optimize the tax benefits you receive from your rental real estate.