Aspen, Colorado is known throughout the world for its idyllic landscape, world-class skiing, and hourly Mariah Carey sightings. It’s an amazing place to live, assuming, of course, you can afford it.
You see, the ol’ 81611 is one of the more expensive zip codes in America; if you want a piece of dirt within the city limits, it’s going to cost you well over seven digits. This is precisely why people like me are stuck living 15 miles away in a middle-class haven, content to rub elbows with the stars only as a visitor, never a neighbor.
Doing business in Aspen is no cheaper; rents are painfully high for commercial space. And when that’s the case, the best business to be in is usually that of a landlord. But being a landlord is hard work; you must constantly deal with late hours and annoying tenants.
Well, that appears to be exactly what HR 1, the tax proposal released by House Republicans last week, is asking you to do.
Allow me to explain:
Over the next four decades, Jack and Jill got aggressive and built an empire, buying so much commercial space that forty years later, the pair co-own 15 commercial properties through 15 separate LLCs.
Managing that much rental real estate, however, is no easy gig. Both Jack and Jill abandoned any other professional pursuits years ago, choosing instead to form a management company and devote all of their efforts to overseeing their properties.
Being landlords has suited Jack and Jill, each pulls in $5 million of rental income annually.
As 2018 looms, however, the long-time union is fracturing. Jack has grown weary of the grind. He would like to step down from the management company to have more time for other activities, including playing golf. The result: Jack and Jill will continue to co-own the properties, but the day-to-day duties will fall entirely on Jill.
This is perfectly fine with Jill. She remains energized and looks forward to spending eight hours a day, five days a week, in the offices of the management company handling the myriad issues that come with hundreds of tenants.
As 2018 unfolds, Jack sticks to his plan and embraces retirement. From time to time he’ll check in on his properties or help Jill out of a jam, but when the year is over, he has only amassed 749 hours of work on the rentals, far fewer than in previous years.
Jill, as is her habit, worked tirelessly. She spent well over 2,000 hours during the year managing the rental properties.
Consistent with prior years, the properties kick off $5 million of rental income to both Jack and Jill.
Why does any of this matter?
Because if the House tax bill that was proposed last week were to become law, Jack, who retired at the end of 2017, will pay federal income tax of $1.25 million on his $5 million of income. Jill, who rolled up her sleeves and got to work, will pay a tax of $2.3 million on her $5 million shares of income.
That can’t be the case, can it? Can the House bill, which has been sold as the path to creating jobs and making America an economic giant again, really be providing an incentive not to work?
It sure can. And it’s a beautiful illustration of how tax reform creates winners and losers, in ways that maybe even the drafters of that reform don’t anticipate. But to understand how Jack ends up rewarded for his laziness while Jill gets punished for managing her empire, let’s take a look at two things: the “real estate professional rules” under current law and the treatment of “pass-through” income under the proposed House bill.
Real Estate Professional Rules
Frustrated by the rise of tax shelters, in 1986 Congress created Section 469 of the tax law, which governs so-called “passive activities.” To illustrate the type of shelter Congress was looking to slam shut, imagine a scenario where a doctor — who earns $300,000 annually — purchases a second home. He rents the home out to someone he knows, and aside from collecting a healthy rent check every month, he has little contact with the tenant.
From a tax perspective, the doctor deducts from his rental income the cost of repairs, utilities, and best of all, the “depreciation” on the house. After these deductions, the property kicks off a generous loss, which the doctor uses to partially offset his income from saving lives.
It’s a win-win-win scenario: the doctor lowers his tax bill, does it primarily through non-cash depreciation deductions, and best of all, while the home is being “depreciated” for tax purposes, in reality, it is appreciating in value.
Appropriately perturbed by this result, Congress added Section 469, which breaks all activities of a taxpayer into two buckets: passive activities and nonpassive activities. Any loss from a passive activity can only be used against income from a passive activity; any excess losses may be carried forward until such time that either 1) passive income is generated, or 2) the passive activity is sold.
In defining “passive activities,” Section 469 makes one thing very clear: all rental activities are PASSIVE. No matter how hard you work, no matter how much you’re there, no matter how many broken shower heads you replace and toilets you unclog, rentals always default to being passive.
For every activity that isn’t a rental, however, whether the activity is passive or nonpassive depends on whether you “materially participate;” thus, it DOES matter how hard you work. Put in enough hours (> 500 hours is the safest test to meet), and the activity becomes nonpassive and any loss can be used without limitation.
Look what this does to our doctor friend. His income from being a doctor is clearly nonpassive; after all, it’s his day job. But the rental property is just as clearly passive because ALL RENTAL ACTIVITIES ARE PASSIVE. As a result, after the advent of Section 469, the doctor can no longer use the rental loss to offset his income from being a doctor. Tax shelter = CLOSED.
But as with all things tax Code, there is an exception to the general rule that all rental activities are passive. If you qualify as a “real estate professional,” then you overcome the presumption that all rentals are passive, and provided you “materially participate” (that 500-hour test again) your rentals will become nonpassive, and thus any rental losses could be claimed against other income with impunity.
I don’t want to get into tremendous detail regarding the real estate professional rules because I’ve discussed them at great length here. But essentially, it works like so: if you make your living in a “real estate trade or business”– think construction, development, brokerage, operation, leasing, management, etc… — then you can count the hours spent in that real estate business to the two real estate professional tests of Section 469(c)(7):
- More than half your time during the year must be spent on your real estate trade or business (the “more than half” test), and
- You must spend more than 750 hours on your real estate trade or business “the more than 750 hours test”).
If you satisfy BOTH tests, you are a real estate professional, which means your rentals aren’t doomed to be passive. Instead, if you materially participate in those rentals — and the standard of 500 hours can be measured on a combined basis if you elect to aggregate all of your rentals together — then your rental activity will be nonpassive.
Two important things to note about the real estate professional rules:
- They are not elective. If you meet the two tests discussed above, you are a real estate professional. And if you then materially participate in your rentals, they become nonpassive.
- Since the inception of the rules in 1993, people have taken great pains to qualify as a real estate professional. If you had rental losses, you wanted to be a real estate pro so you could use your losses without limitation. But beginning in 2013, you also cared about being a real estate professional if you had rental income, because only by making the rental income nonpassive could you avoid the application of the 3.8% net investment income tax. As a result, people have ramped up rental hours, eschewed non-real estate hours, and make elections to aggregate rentals, all in an effort to meet the “more than half” and “more than 750 hours” standards.
Next, let’s apply the real estate professional rules to Jack and Jill in 2018:
Newly retired Jack worked 749 hours during 2018, with all of his time devoted to real estate. So while he satisfies the “more than half” test by default — by having no other business activities — he will not satisfy the “more than 750 hours test.” As a result, he is not a real estate professional during 2018, and thus his entire $5 million of rental income is PASSIVE.
Jill, on the other hand, worked well over 2,000 hours managing her rentals during 2018, and like Jack had no other business activities. Thus, she satisfies both the “more than half” and “more than 750 hours” test and qualifies as a real estate professional. Because Jill has also previously elected to aggregate her 15 rental activities together for purposes of measuring whether she materially participates, her 2,000 combined hours more than satisfy that standard, and thus her $5 million of rental income is NONPASSIVE.
House Bill HR 1:
Last week, the House launched its opening salvo in the battle for tax reform by issuing HR 1, a 429-page proposal meant to simplify the tax law while providing cuts to the working class. (if you’re interested in a full analysis of the bill, read here.)
The bill implements a promise that was made by President Trump on the campaign trail that he would revamp the tax treatment of so-called “flow-through” entities. Certain businesses — namely S corporations, partnerships (including LLCs) and sole proprietorships — do not pay tax at the business level; rather, the income of the business is allocated among the owners, who pay the corresponding tax on their individual returns at their individual rates, which under current law reach a high of 39.6%.
The President promised that in conjunction with dropping the corporate rate, he would provide a low unified rate on ALL business income, including the flow-through income of S corporations and partnerships. The House bill attempts to do just that, but with a very interesting and inequitable twist.
Under a new provision of the Code — Section 4 — the House bill would provide that, as promised, flow-through income would be subject to a top 25% rate. But here’s the catch: the only way you can guarantee that all of the income you receive from your LLC or S corporation is taxed at that 25% rate is to be a passive owner.
If you are not a passive owner — in other words, you materially participate in a non-rental activity, or you qualify as a real estate professional and materially participate in your rental activities — the House bill does not want you to be able to convert “service income” that would normally be taxed at ordinary rates — which will continue to be as high as 39.6% — into income taxed at the favorable 25% rate.
As a result, if you are a nonpassive owner of an entity, the default treatment of your income is that only 30% of the income is subject to the favorable 25% rate; the remaining 70% of the income is taxed at ordinary rates at a high of 39.6%.
Application to Jack and Jill
As a reminder, by virtue of his failure to qualify as a real estate professional, Jack’s rental activities are passive, as is his $5 million of income. Under the House bill, this turns out to be a great thing for Jack, because as a passive owner of his 15 LLCs, the entire income allocated to him is taxed at the favorable 25% rate, resulting in a tax bill (before considering the 3.8% net investment income tax) of $1.25 million.
Jill, however, qualified as a real estate professional, swinging her 15 rentals from passive to nonpassive. As a result, under the House bill, her $5 million of rental income is treated as being 70% attributable to her services and is taxed at an increasing ordinary rate that tops out at 39.6%. Only the remaining 30% is taxed at 25%. This results in a total federal tax bill (before considering the 3.8% self-employment tax, which will wash with the net investment income tax incurred by Jack) of nearly $2.3 million.
That’s right: By retiring, Jack can retain the same ownership of his rental properties as Jill, earn the same $5 million of income as Jill, but save over $1 million in tax.
Jill, meanwhile, who has now worked twice as hard to make up for Jack’s absence, has to stomach the fact that Jack paid $1 million less in tax to stay at home.
So what options does Jill have? Not many, really. Again, the real estate professional rules are not elective; so if she continues to spend all of her time on her rentals and those hours exceed 750, she will subject 70% of her income to the higher rates. The proposed legislation allows nonpassive owners the opportunity to use a formula to determine a higher capital percentage than 30%, but that may not prove fruitful. Her only choice if she wants to save $1 million, it would appear, is to STOP WORKING.
This, as you might guess, is bad tax policy. You generally don’t want to provide people with a $1 million incentive to pack it in.
But that’s exactly what the House bill does.