Section 199A: Rental Real Estate

Just based on the people I know (especially in our urban centers), many Americans thrive off passive income. Now there are several sources of passive income but one common passive income stream-especially in places like NYC-is rental income. You know: you buy a two-family house somewhere in Brooklyn’s Bed-Stuy section, pay an arm & a leg, and then rent one of the units for an arm and a leg to pay your astronomical mortgage. For income tax purposes, these rental activities are considered "passive" activities, and a loss on a passive activity is not deductible against non-passive income, such as wages. But, a special rule lets you deduct up to $25,000 of losses from rental real estate in which you actively participate. Furthermore, you may deduct more than $25,000 if you can show that you materially participated as a real estate professional. Maybe you are asking, what does this have to do with Section 199A, anyway (and we’ll soon get to that too)? And, what happens when you don’t have a loss?

So one of the first requirements to take the 20% 199A deduction is that you must have what is called a Section 162 business. Meaning, your business must have a profit motive, i.e., you must be in it to make money; not a hobby or something casual or the like.

It is important to have that established because if you do not have a loss on the rental real estate, I am sure you'd want to be able to get the 20% deduction to lower your tax bill. The issue with rental real estate is that it's generally passive in nature and thus may contravene what constitutes a section 162 business. The good news is that for most rental real estate activities, there is a safe harbor rule that positively umbrellas most rental real properties under section 162. 

Additionally, when there is "self-rental", i.e., entity A rents space from B but both have common ownership, then lessor entity is considered a "de facto" sec 162 business. However, certain rental real estate activities will not be covered under the safe harbor rules. Personal use of property for more than 14 days, for example, will not qualify for the safe harbor rule. Any property or grouping of properties rented using "triple net leases" do not qualify for safe harbor protection. Triple net leases are leases that require the tenant be responsible for paying the real estate taxes, insurance and maintenance expenses on the property. Notwithstanding, the IRS has indicated that it in certain cases it will look at the specific facts and circumstances when determining whether a business meets section 162 requirements.

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