“There are horrible people who, instead of solving a problem, tangle it up and make it harder to solve for anyone who wants to deal with it.
Whoever does not know how to hit the nail on the head should be asked not to hit it at all.”
– Friedrich Nietzche
While the IRS as a whole is by no means “horrible,” the new Final Regulations regarding Section 199A of the Internal Revenue Code must seem that way to landlords who lease property under triple net leases. The vast majority of these will not be considered to be “active trades or businesses” for purposes of qualifying for the 20% deduction that will be available to most active landlords.
Code Section 199A was introduced to the Internal Revenue Code as part of the 2017 Tax Cuts and Jobs Act with the intent of giving taxpayers some degree of parity with the 21% income tax bracket bestowed upon large and small companies that are taxed as separate entities (known to tax professionals as “C corporations”. C corporations are different than “S corporations,” as S corporations report their income under the “K-1” system that causes the shareholders to pay the income tax on their personal returns).
Since the term “trade or business” was not defined under Section 199A, the real estate community has been waiting for the Final Regulations which were released on Friday, January 18, and basically follow what the Proposed Regulations (released last August) said, which is that which is that passive investors are not considered to be an active trade or business, even though they take significant economic risks and may work hard to verify that the tenants pay the taxes, insurances and maintenance of the leased property, comply with applicable law and otherwise do what tenants are supposed to do.
The practical result will be that landlords will need to become active and possibly renegotiate lease terms to have at least a chance of being eligible to have the deductions that other landlords will have, or to perhaps qualify under the new safe harbor rules that allow the deduction to non triple net leases if they satisfy the 250 hour per year requirement, which requires tabulation of the work hours of landlords and agents of landlords, and certain time log and verification procedures.’
This seems very unfair since REIT (Real Estate Investment Trusts) income will often include triple net lease profits that will qualify for the Section 199A deduction, and C corporations only have to pay the 21% rate on net income from triple net leases.
Tax professionals, and masochists may enjoy or derive a better understanding by reading on.
The new Final Regulations refer to several Supreme Court cases to aide in defining what types of enterprises will qualify as a trade or business, and these cases do not bode well for landlords of triple net leases. For example, the Final Regulations cite to the Supreme Court’s 1987 landmark “trade or business” case, Commissioner v. Groetzinger, which held that to be engaged in a trade or business the following two requirements must be met:
1. The taxpayer’s involvement must be continuous and regular; and
2. The primary purpose of the activity must be for income or profit.
The very definition of a triple net lease seemingly disqualifies the majority of triple net landlords from qualifying under this definition under the assumption that they do not have continuous and regular involvement.
With triple net leases, the tenant is usually responsible for the three “nets”: real estate taxes, building insurance, and maintenance. By having the tenant be responsible for most of the on-site responsibilities, the landlord is able to spend more time and effort buying and selling other properties and therefore investing more into the economy.
In turn, triple net lease agreements usually benefit the tenant because the pricing of the agreement will reflect the fact that the tenant will be responsible for a lot of the on-site responsibilities. Now tenants have the upper hand when landlords ask to be allowed to provide at least 250 hours of services per year (cumulatively, as to all leases that the landlord will aggregate under the complicated aggregation rules, which are discussed in our blog post entitled Real Estate: Investing with Section 199A: Don’t Let Your Deductions Fly Out the Window).
The new Final Regulations do, however, contain one saving grace for taxpayers with triple net leases by quoting the 1941 Supreme Court case of Higgins v. Commissioner.
In Higgins the Supreme Court stated that the determination of “whether the activities of a taxpayer are ‘carrying on a business’ requires an examination of the facts in each case.” Since it is a factual determination, a taxpayer with the right fact can successfully argue that his or her triple net or almost triple net rental enterprise should constitute a qualified trade or business.
However, doing so will be a tough and expensive hurdle for many landlords to jump over.
Perhaps Congress will act in a compromise to assist the continued growth in the economy in recognizing that taxpayers with triple net leases put themselves at significant financial risk, in that tenants like Toys R Us and Sears may go bankrupt and leave a landlord high and dry after many months of eviction and then bankruptcy litigation. Many landlords are not aware that the bankruptcy law allows tenants to have the court terminate long term leases and limit damages to one year of rent.
Non-triple net lease landlords who spend considerable time in their leasing activities can take considerable comfort from Notice 2019-7, which was published alongside the new Final Regulations. The Notice provides the above-mentioned safe harbor for non-triple net leases to be “treated as a trade or business solely for the purposes of Section 199A.”
Under the new safe harbor, non triple net rental real estate may be treated as a trade or business, if the following three requirements are met:
1. separate books and records are maintained to reflect income and expenses for each rental real estate enterprise;
2. 250 or more hours of rental services are performed per year with respect to the rental enterprise; and
3. the taxpayer maintains contemporaneous records, including time reports or similar documents, regarding the following: 1) hours of all services performed, 2) description of all services performed, 3) dates on which such services are performed, and 4) who performed the service.
Interestingly, while triple net lease arrangements outside of REITs will likely not qualify under Section 199A, banks that are taxed as S corporations, or partnerships, are eligible for the deduction, although in many respects a loan is like a triple net lease where the landlord has put money out for a long term series of payments, where in many cases the vast majority of the value is in the years of payments to be received, just like a long term promissory note.
It is even more disturbing that other types of businesses involving much less risk on the part of the owner qualify for the deduction. These include brothels, franchisors and vending machine owners. How is it possible that a brothel owner sitting back and receiving rent form independent contractor “professional entertainers” may qualify for the benefits of Section 199A, but taxpayers with triple net leases do not?
For more information on the different types of businesses that qualify for Section 199A, please see our post entitled Beautiful Losers: The Discriminatory Nature of the 199A Proposed Regulations, especially if you like Bob Seger and the Silver Bullet Band.
As the infamous Marquis de Sade once stated, “Social order at the expense of liberty is hardly a bargain.”
To view our on-demand webinar on how Section 199A impacts real estate investors or to receive our white papers on this topic, email [email protected] and mention the “secret decoder ring.”
If you are a landlord or tax advisor, thanks sincerely for what you do for others. If you are a triple net tenant it is time to ask the landlord if you can give up some of the responsibilities so that the landlord pays less tax on the rent income.