Real Estate Owners, Is it time to Switch From A Triple Net Lease?
Section 199A Qualified Business Income Deduction:
By Grant D. Ison
Summer Associate 2018, 3L UC Law School
Congress recently passed the Tax Cuts and Jobs Act of 2017. With it came the 199A Qualified Business Deduction (QBI Deduction) for pass-thru businesses.
The QBI Deduction allows for a deduction of up to 20% of qualified business income. The law is unclear, but using a triple-net lease might disqualify real estate owners from receiving the deduction.
A limitation applies for certain service providers, married joint filing taxpayers with income over $315,000, or single taxpayers with income over $157,500.
When a taxpayer reaches this limit, the QBI Deduction cannot exceed the greater of 50% of W-2 wages (regarding the qualified trade or business), or 25% W-2 wages plus 2.5% of the unadjusted basis of all depreciable assets (regarding the qualified trade or business).
The precise mechanics of the QBI deduction are beyond the scope of this article, but note that these limitations begin to phase-in and modify the 20% deduction at the $315,000 and $157,500 threshold.
Once the taxpayer has an income of $415,000 (married joint filing) or $207,500 (single taxpayer), the deduction becomes fully dependent on the W-2 wages and depreciable property.
The law isn’t clear whether the QBI Deduction will apply to real estate triple net lease properties. Many believe that, given the history of regulations governing the topic, triple net lease properties will not be a qualified trade or business.
In the preamble of IRC Section 1411, which are regulations governing the imposition of the net investment income tax, the IRS states, “the Treasury Department and the IRS do not believe that the rental of a single piece of property raises to the level of a trade or business in every case as a matter of law.” (Preamble, T.D. 9644).
This means that whether the triple net lease qualifies as a qualified trade or business could come down to factors of the courts’ interpretations, the property, the number of properties rented, the day-to-day involvement of the owner or its agent, and the rental. To safely work within these factors, real estate owners should transition from triple-net leases to a modified gross lease.
Largely based on REIT (Real Estate Investment Trusts) analyses, some scholars think triple-net leases will work as a qualified trade or business within the rules of the QBI Deduction. Scholars also believe triple-net leases will be included in the deduction, because REITs have passive investors who reap the rewards of their investment and provide no active service to make the income.
That scholarly analysis is entirely speculative. The QBI Deduction is a large tax saving for pass-thru entities. The safest way to ensure your real estate leasing business receives that savings, before receiving further guidance from the IRS, is to transition from a triple-net lease to a modified gross lease or other lease structures.