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Filing requirements for rental activities.

Filing Requirements for Rental Activities

Internal Revenue Code (IRC) Section 6041 (a) requires every person engaged in a trade or business to file informational returns (Form 1099-MISC) for each calendar year with respect to payments made to another person in the form of non-employee compensation or fees paid for services received. This section requires an accumulation of all payments made throughout the year and provides a dollar threshold limit of $600 or more in applying the filing requirement. Treasury Regulations make it clear that the phrase "all persons engaged in a trade or business" includes nonprofit organizations.(1) However, there is no discussion or guidance on the classification of a rental activity.

It is the purpose of this article to clarify the term "trade or business" as it applies to rental activities and provide guidance in determining the filing requirements under IRC 6041 for payments made to service people.

Trade or Business

The term "trade or business" is not defined in the Code or regulations, and the courts have not provided a satisfactory definition, as no one definition applies to all situations. Therefore, we must look at various Code sections to determine the definition. There are various ambiguities and inconsistencies in the definition of a trade or business as it pertains to a rental activity, including operating deductions, passive activity losses, net operating losses, self-employment tax and the Section 179 deduction.

Operating Deductions

IRC 212 allows deductions for ordinary and necessary nonbusiness expenses which are paid or incurred in a rental activity, such as the cost of repairs, insurance premiums and similar expenses. Other expenditures are made deductible by specific provisions of the Code, such as interest (163), real estate taxes (164) and depreciation (167 & 168).

It should be noted that normally 212 investment expenses are treated as itemized deductions, whereas rental expenses are deductible above the line for determining adjusted gross income for individuals.(2)

Passive Activity Losses

A rental activity is generally treated as a passive activity whether or not the taxpayer materially participates in the activity. In the case of rental real estate activities in which an individual actively participates, a special rule permits the application of up to $25,000 of losses. The point here is that a rental real estate activity is a passive activity and not a trade or business undertaking by statutory definition.(3)

Net Operating Losses

The requirement to file annual income tax returns may result in certain inequities for taxpayers who experience cyclical patterns of income and expenses. To provide a partial relief against this treatment, a deduction is allowed for net operating losses. A net operating loss is intended as a relief provision for business income and losses. Therefore, only losses from the operation of a trade or business (or profession) can create a net operating loss.

With regard to losses incurred by a taxpayer in connection with the sale or rental of real estate, the allowance of the net operating loss depends upon the taxpayer's status as a dealer or an investor with regard to the property.(4) For example, if land is held primarily for investment rather than for sale in the ordinary course of business, the owner would be considered a real estate investor and ineligible for the net operating loss deduction.

To cloud the issue, under another court case, rent is considered business income even if the taxpayer maintains only one rental property.(5) Therefore, rental losses are included as business losses under IRC 172. However, rental losses that are limited under the passive activity rules are also suspended in determining the net operating loss deduction.

Self-Employment Tax

Rent from real estate is not self-employment income unless it is business income of a real estate dealer or income in a business where substantial services are rendered to the occupant, such as a hotel or motel, etc. This again points to the activity as an investment activity.

Section 179 Deduction

IRC Section 179 allows a taxpayer to expense up to $10,000 of the cost of qualifying depreciable property. In general, the property for which a 179 deduction may be made is tangible personal property purchased for use in the active conduct of a trade or business.

The special deduction is not available for real estate or property held merely for the production of income because it is not considered a trade or business.

Rental Property and

Section 6166

The government has long asserted that the mere ownership and collection of rent with respect to commercial or residential real estate is not enough to constitute a trade or business within the meaning of Section 6166.(6) However, in IRS Letter Ruling 8524037, the IRS concluded that the decedent's rental activities constituted an active trade or business within the meaning of Section 6166. In making this determination, the IRS placed primary reliance on the decedent's actual day-to-day physical operation of the property rather than his involvement with the various financial aspects of leasing. While private letter rulings cannot be relied upon as authority by other taxpayers, they do provide interesting guidelines in identifying whether a real estate activity constitutes an active trade or business and qualifies for installment payment of estate tax.(7) It is still uncertain whether the IRS will be more liberal in the future by expanding the definition of a trade or business to include rental activities.

Capital Asset vs. Business Asset

IRC Section 1221 defines a capital asset as property held by the taxpayer but not including depreciable property or real estate used in a trade or business. Taken alone, this would mean that gains on the sale of real estate of this type would result in ordinary income. However, Congress enacted Section 1231 to stimulate the economy. This provision extended capital gain treatment to real property used in a trade or business even though they were not capital assets. However, a net Section 1231 loss remains an ordinary loss.

The following two court cases demonstrate the inconsistency in applying the trade or business definition to real estate. According to the Tax Court and the IRS, the renting of a single piece of residential property constitutes use of the property in a trade or business.(8) In another case, however, the Court of Appeals for the Second Circuit disagreed with the Tax Court and concluded that the renting of a single residence does not constitute a trade or business in every case.(9) Therefore, the rental of a single residence by a taxpayer who was not in the business of renting properties for a livelihood was not a trade or business.

Investment Activity

Generally, a trade or business has been characterized as an activity carried on for a livelihood or for profit - a real economic profit independent of any tax saving. Based on this premise, it was apparently conceded by the courts and the IRS that the rental of property constituted a trade or business even though it took only a small part of the owner's time. However, more recently the IRS has taken the position that the renting of property does not necessarily constitute a trade or business. The rental of property is actually an investment activity within the meaning of IRC 212 because of the amount of time an individual devotes to managing the property.

It appears that Congress did not intend that a rental activity should be considered a trade or business. Code Section 62 allows certain deductions in determining adjusted gross income. Separate classes were created for trade or business deductions and for deductions attributable to rents. If renting were a trade or business in every case, there would not have been any need for a separate distinction in IRC 62. In essence, IRC 212 and 62 consider renting as an investment activity.


Normally a trade or business activity turns to IRC 162 for definitions and specific allowable deductions. However, this area does not pertain to rental activities. Rental deductions are allowed under IRC 212 as investment expenses, and IRC 6041 has not provided a sufficient definition to include rental activities.

Therefore, it can be concluded that the preparation of Form 1099-MISC is not required for payments to the gardener, painter, pool service and property manager, etc., because a rental activity is primarily an investment activity.

This position will remain until the IRS issues an announcement expanding the types of transactions for which informational returns must be filed. It appears too difficult for the IRS, through its administrative process, to directly request or exempt landlords from this filing requirement. However, property owners may file informational returns regardless of the filing requirements. Footnotes

(1)Reg 1.6041-1(b).

(2)IRC 62(a)(4).

(3)IRC 469.

(4)Guggenheimer v. Comm., 54-1 UST 9152.

(5)Lagreide, 23 TC 508, Dec. 20, 721.

(6)Rev. Ruling 75-365, 1975-2 CB 471.

(7)IRS Letter Rulings 8524037 (3/18/85) and 8942018 (7/21/89).

(8)L. Hazard, 7 TC 372, Dec. 15,273 (Acq).

(9)Grier v. U.S., (DC) 54-1 USTC 9268, Aff'd per Curiam, (CA-2) 55-1 USTC 9184.
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Author:Dishman, Ben L.
Publication:The National Public Accountant
Date:Mar 1, 1991
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