The maze of real estate rentals.

• Author: Hesse, Christopher W.

The Internal Revenue Code is a labyrinth--you might think that you have visited every room only to discover an opening that leads to yet another maze to explore.

Rental real estate activities are found in several of the labyrinth rooms of the Code. They can be passive (by default), recharacterized as nonpassive (e.g., net rental income generated from leasing to the taxpayer's materially participating business), or materially participating (e.g., a real estate professional who meets the material participation tests). Status under the passive activity rules dictates the status for purposes of the net investment income tax. Rental real estate activities may be a trade or business (usually) or an investment (in the extreme, a triple-net long-term lease of bare ground). They may generate qualified business income (QBI) (for the trade or business activities) even though the owner is passive. If the real estate activity generates active trade or business income or loss, that income or loss enters into the Sec. 179 computation. Usually the rental real estate does not generate self-employment income (or loss), regardless of status for passive activities, QBI, or Sec. 179.

Rental real estate and passive activities

Without getting too deep into the labyrinth (there is no intention here of writing a book), rental real estate activities default to passive status. (1) Real estate rentals are also subject to recharacterization rules for passive activity purposes. (2) For example, the net rental income from substantially nondepreciable property is characterized as nonpassive, but a net loss is passive. (3) The result is the same if the owner of the rental real estate leases the property to a trade or business in which the taxpayer materially participates. (4) The recharacterization rules apply regardless of whether the rental activity rises to the level of a trade or business (more on that later).

A real estate professional has the opportunity to have the activity treated as nonpassive if he or she materially participates in the rental real estate activity. (5) A real estate professional is one who spends more than one-half of her personal services performed in all trades or businesses during the year in real property trades or businesses in which she materially participates. She must also perform more than 750 hours of services during the year in real property trades or businesses in which she materially participates. The taxpayer alone must meet both tests because there is no spousal attribution. (6) Counting and documenting hours is important, not only for the real property trades or businesses but for other trades or businesses as well, in order to properly determine the denominator of the more-than-50% test.

Real property trades or businesses are those involved in development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, and brokerage of real property. (7) The regulations do not further define these terms. The real estate professional status merely "turns off" the default status of rental real estate as a passive activity. (8) The taxpayer must then separately establish nonpassive status by material participation or, for an activity generating net income, significant participation. (9) Other recharacterization provisions may result in nonpassive status.

Rental real estate and the net investment income tax

The net investment income tax applies to the lesser of net investment income or the excess of adjusted gross income (AGI) over the threshold amount. (10) The term "net investment income" is a misnomer. It includes interest, dividends, annuities, royalties, rents, other gross income, and net gain (to the extent includible in taxable income) from the disposition of property, of a trade or business that is a passive activity with respect to the taxpayer, less the deductions allocable to those items of gross income or net gain. (11) Thus, net investment income may include business income, if that business income is passive.

A taxpayer is not subject to the net investment income tax (i.e., the income is not net investment income) on rental real estate activities if they are not passive. (12) Rental real estate activity income may be recharacterized as nonpassive if it is from a significant participation activity (an activity in which the taxpayer participates for over 100 hours but does not materially participate), property rented incidental to a development activity, or a self-rental. (13) If so recharacterized under the passive activity rules, the income is also not net investment income for purposes of the net investment income tax.

The real estate rental activity of a real estate professional that is not per se passive will be nonpassive if the taxpayer establishes material participation or significant participation in the real estate rental activity. If considered non-passive under the passive activity rules, the income is also not net investment income. (14)

Not all rental real estate activities recharacterized as nonpassive will escape the net investment income tax labyrinth. The rental of substantially nondepreciable property (less than 30% of the unadjusted basis of the property used in the rental activity is depreciable) is not from a passive activity (15) but is considered as property held for investment. (16) The rental of substantially nondepreciable property will be subject to the net investment income tax unless it is also a self-rental property.

Rental real estate and QBI

Solely for purposes of the QBI deduction, the rental of tangible property to a trade or business that the taxpayer (or a passthrough entity) conducts that is commonly owned is treated as a trade or business. (17) The same person or group of persons must own, directly or by attribution under Sec. 267(b) or 707(b), at least 50% of each trade or business and the rental activity. This deemed trade or business status does not include a rental to a C corporation trade or business. (18) Meeting the commonly owned test satisfies the trade or business requirement and qualifies the activity for the QBI deduction, even if the minority owner of the rental activity has no ownership in the trade or business activity to which the property is leased.

Even if the taxpayer does not meet the requirements for the deemed trade or business (e.g., the operating business to which the property is leased operates as a C corporation, or is not commonly owned with...