One of the biggest questions posed by the real estate industry when the QBI deduction was first enacted was how the IRS would define a trade or business. Most of the industry experts believed the Section 162 definition of a trade or business would be most appropriate and the IRS agreed. While there are many definitions of the Section 162 trade or business found across a myriad of court cases and Code sections, there is at least some precedent for the majority of situations regarding real estate. For instance, the Fackler and Gilford cases indicate that the rental of a single commercial building or the rental of multiple properties within one entity rises to the level of a trade or business. On the flip side, Neill and Rev. Rul. 75-322 indicate that a single triple-net lease is not a trade or business. The results may not always be favorable, but at least there is guidance to plan appropriately.
In addition to the definition of a trade or business, the same section of the regulations provides a special carveout for rental activities. If a property is rented to a more than 50% commonly owned trade or business, the rental activity will be deemed to rise to the level of a trade or business as well. This is important for operating entities that previously separated the ownership of their building to a related LLC for legal reasons. Taxpayers should be wary, however, that when a rental activity is more than 50% owned by a specified service trade or business (or share common ownership in excess of 50%), the rental activity will also be characterized as a specified trade or business. This means that the rental would no longer qualify for the QBI deduction.
Arguably the most favorable of the rules introduced in the regulations are the aggregation rules. Trades or businesses that have 50% or more common ownership and share common characteristics can aggregate their qualified business income, W-2 amounts, and property amounts. Some would argue that these are the most favorable provisions because they allow a great deal of flexibility. Minority owners can aggregate even if the majority owners do not and vice versa. Taxpayers can group qualified businesses in any manner in which they please. For example, assume a taxpayer has four businesses that qualify for aggregation. The taxpayer could group businesses 1 and 3 but leave businesses 2 and 4 separate. Alternatively, the taxpayer could group businesses 1 through 3 and leave 4 by itself. It’s also important to note that just because one owner groups in one manner, it does not mean the other owners have to follow suit.
The key to note is that aggregation cannot help an activity rise to the level of a trade or business. Each activity must rise to the level of a trade or business before it can be aggregated. This would mean that the business of a taxpayer who rents two residences using triple net leases would not automatically qualify as a trade or business. There would have to be additional supporting facts and circumstances present for the activities to rise to the level of a Section 162 trade or business.
Aggregation can be key for real estate groups or taxpayers that own properties of varying ages. Large real estate groups that have a separate management company will benefit from aggregation as the wages of the management company can help increase the limitations on QBI. Additionally, if a taxpayer owns an older but very profitable real estate property that has little in the way of depreciable cost as well as a newer property that has a higher depreciable cost but is low in profitability, aggregation will be a benefit. The high basis in the new property will increase the property limitation on the older, more profitable rental.
Only certain types of property qualify to count as part of the 2.5% of property limitation. The proposed regulations provide additional clarification to a number of nuanced Code sections that could affect the basis and holding period of qualified property. First, improvement property will have a depreciable period separate from that of the property of which it improves. This will be a crucial distinction for landlords who have owned their rental properties for a long period of time.
Second, when a taxpayer purchases a partnership interest from another partner, the taxpayer may be able to record a step-up in the basis of the partnership property for part of the consideration paid. Alternatively, when a partnership makes a distribution to a partner in excess of the partner’s basis in the partnership interest, the partnership can record a step-up in basis in the partnership property. Unfortunately, these types of adjustments do not qualify as part of the UBIA of qualified property.
Third, §1031 exchanges are common in the real estate world and will continue to be, as exchanges of real property are the only allowable like-kind exchanges after December 31, 2017. In a like-kind exchange, the basis of the replacement property received by a seller is generally equal to the basis of the relinquished property, adjusted for any boot or gain recognized in the transaction. The unadjusted portion of the carryover basis is referred to as the exchanged basis and the basis created by the cash and gain recognized is referred to as the excess basis. The regulations provide that the depreciable period of the exchanged basis starts when the relinquished property was placed in service. The depreciable period of the excess basis starts when the replacement property is placed in service post-exchange.
The real estate industry was generally satisfied with the regulations’ definition of a specified service trade or business. An SSTB is not eligible for the QBI deduction, so many real estate brokers and management companies were concerned when the original QBI Code section included the broad terms ‘brokerage services’ and ‘investment management’ in the definition of an SSTB. The proposed regulations make it very clear that brokerage services do not include real estate agents or brokers, and the term investment management does not include directly managing real property.
The QBI deduction in the real estate industry was handed a huge benefit when the Conference Committee added 2.5% of the basis of qualified property as a limitation, a limitation that was not present in the original version of the deduction that was proposed by the Senate. The proposed regulations once again provided favorable treatment to members of the real estate industry. As further guidance is provided by the IRS and Treasury department, your advisors at Withum will keep you informed.