The 3.8% question: Is your rental property a “trade or business?”

January 28th, 2013 by Joe Kristan
Flickr image courtesy John Snape under Creative Commons license

Flickr image courtesy John Snape under Creative Commons license

The IRS isn’t saying.

It matters for real estate operators. The proposed regulations on the Obamacare “Net Investment Income Tax” impose the 3.8% levy on rental income, but not for “material participants” in a rental “trade or business.” Tax Analysts reports ($link) that IRS attorney David Kirk weasels out of saying what “trade or business” means:

“On one end of the [section 469(c)(7)] spectrum, you have the real estate pro that owns one-tenth of lower Manhattan and lives, breathes, and dies by occupancy, building up, renting out,” Kirk said, adding that that individual would be considered to be in the trade or business of renting real estate.

Kirk declined to say whether someone on the other end of the spectrum — the real estate broker who not only lists houses but also owns a couple of townhouses or condos — would be considered to be in the trade or business of renting real estate. “I’m not really comfortable coming out and saying what a trade or business is,” he said.

The term “trade or business” has been defined some under Section 108(a)(1)(D), which allows taxpayers to exclude debt cancellation income if the debt was on “trade or business” real property. The IRS discussed the issue in PLR 9840026 (some citations omitted):

The rental of even a single property may constitute a trade or business under various provisions of the Code. However, the ownership and rental of property does not always constitute a trade or business. The issue of whether the rental of property is a trade or business of a taxpayer is ultimately one of fact in which the scope of a taxpayer’s activities, either personally or through agents, in connection with the property, are so extensive as to rise to the stature of a trade or business. Bauer v. United States, 168 F. Supp. 539, 541 (Ct. Cl. 1958); Schwarcz v. Commissioner, 24 T.C. 733 (1955); See Higgins v. Commissioner, 312 U.S. 212 (1941) (management of taxpayer’s own investment portfolio not a business).

In Rev. Rul. 73-522, 1973-2 C.B. 226, the Service held that rental of real property under a “net lease” does not render the lessor engaged in a trade or business with respect to such property for purposes of section 871 of the Code

It was unwise to make “trade or business” status key to this tax; it makes it difficult for taxpayers to know whether it applies and it encourages taxpayers to be agressive. They should just say that if you achieve non-passive treatment as a real estate professional, you don’t pay the tax.

Related: Real Estate Professional Status – Becoming More Important – Very Hard To Prove (Peter Reilly)

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