In December of 2017, the Tax Cuts and Jobs Act further extended the benefits of investing in real estate by introducing a new “qualified business income” (QBI) deduction under IRC Section 199A that further reduces net rental real estate income by up to 20%.
We have received some inquiries about the impact of the new Section 199A on real estate properties with triple-net leases. Since the inception of Section 199A, experts have continued to speculate how it will impact real estate activities, particularly those under a triple-net leases. I am personally inclined to say that a triple-net lease could prevent the deduction under Section 199A.
The Triple-Net Challenge
A triple-net lease requires the lessee to pay the landlord rent as well as take care of real estate taxes, building insurance, and property maintenance costs. Therefore, in a triple-net lease, the lessee bears all the burdens of ownership, and the landlord usually has little to no involvement in the property management. So, if all that’s being handled by the tenant, what’s the landlord doing? Pretty much, just collecting a check, and there lies the potential problem.
A rental property qualifies for the Section 199A deduction if:
- the rental property qualifies as a trade or business under tax code Section 162, or
- you rent the property to a commonly controlled trade or business.
Assuming you can’t use the commonly controlled route (option 2 above), your rental properties need to rise to the level of a trade or business (as defined by Code Section 162) to get your Section 199A deduction.
To meet that requirement, you’ll generally need to have regular and continuous involvement with your rental activities. And the proposed regulations require you to look at each rental activity separately when determining whether it is a trade or business—aggregation doesn’t help you with this.
Many triple-net lease rental activities likely fail the regular and continuous activity test and won’t qualify for the Section 199A deduction. For example, in Neill, the Board of Tax Appeals (the precursor to the Tax Court) held that a single property leased on a triple-net basis is not a Code Section 162 trade or business.
How to Overcome the Challenge
While there are differences of opinion between tax professional about the topic, there some things that are clear:
- Triple-net leases increase the chances of a rental property not rising to the level of a trade or business. Real estate investors looking to claim the deduction under Section 199A may want to consider avoiding the use of the triple-net lease or hold their real estate investments under a REIT.
- Investors should keep track of their time and the time their staff spend working for the real estate business. Track time spent to inspect properties, property management (pay bills, advertise, etc), searching for tenants, and negotiating with vendors.
- The higher the number of units rented, the greater the chance the IRS and tax courts will conclude that the real estate activity is a trade or business.
- Taxpayers with minimal involvement in their rental activities need to be prepared for the possibility that any QBI deduction to be challenged upon an audit.
While there are some differences of opinion on the topic, there are some things that are clear. The new Section 199A makes it clear that simply owning rental real estate is not a trade or business that qualifies for the QBI deduction. Therefore, the investor must truly operate the real estate investments as a business of real estate investing to actually qualify for the QBI deduction.