United States

IRS expects consistency for rental businesses claiming 20% deduction

Status may trigger requirement to file Form 1099, compromise exchanges

TAX ALERT  | 

Guidance included with the recently released Qualified Business Income deduction regulations makes clear that taxpayers hoping to take the 20 percent deduction against their rental real estate income should be sure they are consistently applying the requisite trade or business standard in other areas of the tax code.

As outline in our prior alert, the IRS released final regulations under section 199A on January 18. The IRS declined in those regulations to provide additional guidance regarding the definition of a “trade or business.”[1] That topic is of considerable interest to owners of rental real estate because rental income only qualifies for the 20 percent deduction if the underlying activity constitutes a trade or business as defined in section 162 of the Internal Revenue Code.

Despite their decision to withhold additional guidance in this area, the IRS nonetheless highlighted their expectation that taxpayers asserting trade or business status should similarly conclude in other relevant areas of the tax code. For example,

  • Form 1099-MISC: A taxpayer engaged in a trade or business that makes payments in excess of $600 to non-corporate service providers must generally provide the service provider(s) and the IRS with Form 1099-MISC and related filings by Jan. 31 each year.
  • Entity classification: Taxpayers who engage in certain joint undertakings – such as owners of tenants in common interests in rental property – must generally treat that activity as a partnership for income tax purposes, if it constitutes a trade or business. This would require the filing of a partnership return.
  • Like-Kind Exchanges: Trade or business status, and the related requirement to file a partnership tax return, may also have implications on the owners’ ability to exchange their real estate interests and qualify for tax deferral pursuant to the like-kind exchange rules.
  • Business interest limitations: A taxpayer conducting a trade or business is generally subject to the new 30 percent business interest limitation on its business interest expenses paid or incurred for tax years beginning after 2017.

Owners of rental real estate that are hoping to enjoy the benefit of this new 20 percent deduction on their 2018 filings should be sure they are complying with other provisions of the tax code where trade or business status is relevant. Failure to do so increases the likelihood that the IRS will challenge the taxpayer’s trade or business assertion and will create exposure with respect to the 20 percent deduction.

Taxpayers should also be aware of the other implication, potentially unintended, of asserting trade or business status – especially those taxpayers with structures designed to take advantage of the like-kind exchange provisions.
 

[1] The IRS did provide comfort for some taxpayers via Notice 2019-07, which contains a proposed safe harbor in this area. However, taxpayers must satisfy somewhat onerous participation (250 hours) and record keeping requirements before the safe harbor can apply.

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