For many taxpayers engaged in rental real estate activities, one criterion for certain beneficial tax treatments is that the taxpayer be engaged in an active trade or business. Landlords who enter triple net leases with their tenants are generally not considered to be engaged in an active trade or business. As the usage of triple net leases for rental activities continues to grow, it is important to understand how the IRS defines a triple net lease.
Among real estate and tax professionals, a lease will generally be classified as triple net if the majority of the burdens of ownership become the responsibility of the tenant. The most common “burdens” are maintenance of the structure, property taxes, and insurance. In a basic triple net lease, the tenant is responsible for all repairs and maintenance (including the structural components), the timely payment of property taxes and selecting and paying all required insurance. Essentially, a triple net lease provides the only action the landlord must do is collect the rent owed and ensure the tenant’s possession of the property. For this reason, a landlord who enters a triple net lease is not engaged in an active business.
It should be noted that there is no definition of a triple net lease in the Internal Revenue Code (“the Code”) or Treasury Regulations. As such, the IRS has a degree of flexibility to impose its own definition of a triple net lease. Depending on the context, the IRS may impose a more expansive or narrower definition than the three burdens of ownership discussed above. It is important to know which definition the IRS may apply when determining if a taxpayer is deemed to be engaged in an active trade or business.
Because there is no clear definition of a triple net lease, attorneys and landlords should exercise caution when drafting leases. When landlords retain more of the burdens of ownership, there is a lower risk that the lease will be deemed triple net. The following article examines three recent tax programs that shape the definition of a triple net lease.
In response to the devastating hurricane season of 2005, the Gulf Opportunity Zone Act (“Gulf Act”) was passed to bolster efforts to rebuild areas of Alabama, Louisiana and Mississippi. To encourage investment in impacted communities, the now-repealed legislation provided several tax benefits for taxpayers willing to invest and operate a business within the designated areas.
Under the Gulf Act, taxpayers actively engaged in a trade or business within the designated areas were eligible for an additional first-year depreciation deduction for qualified property. In order to be qualified property, the property must have been used in the active conduct of the trade or business within the designated area. In 2006 guidance, the IRS provided the following example, in which a taxpayer is not actively engaged in a trade or business:
During 2006, PRS, a partnership, constructs and places in service a new small commercial building in the GO Zone and leases it to E, an unrelated party, who uses the building as a fast food restaurant. This building is the only property owned by PRS. The lease agreement between PRS and E is a triple net lease under which E is responsible for all of the costs relating to the building (for example, paying all taxes, insurance and maintenance expenses) in addition to paying rent. Because of the triple net lease, PRS does not meaningfully participate in the management or operations of the building and the building is not used in the active conduct of a trade or business by PRS in the GO Zone. Accordingly, the building does not qualify for the GO Zone additional first-year depreciation deduction.
It should be noted that this guidance merely provides one example of a triple net lease; it does not explicitly define a triple net lease. Landlords may interpret this example to mean that a “double net lease,” e.g., landlord retains the real estate tax burden but not insurance and maintenance burdens, creates an active trade or business. Moreover, the example suggests that landlords can look at factors beyond “the big three burdens” to support active involvement in a business.
Even though the IRS seemed to define a triple net lease to match the traditional understanding, the definition would not be uniformly applied in future guidance. As part of the Tax Cuts and Jobs Act of 2017 (TCJA), section 199A was enacted; creating a new deduction available to certain taxpayers actively engaged in a trade or business.
In order to qualify for the deduction, the income must be from a qualified trade or business in which the taxpayer was actively engaged. The legislation, as enacted, left open numerous questions as to how different structures of rental activities would be treated by the IRS. Landlords who owned large residential properties were likely eligible for the new deduction because residential leases are rarely triple net. However, landlords who owned commercial properties needed to evaluate their leases in light of section 199A. Commercial landlords with long-term leases that placed the burdens of ownership on the tenant would likely be ineligible for the benefits of section 199A. Once again, landlords were not provided with a clear definition of what constitutes an active business.
Hoping to provide some clarity for landlords, the IRS issued a safe harbor rule in 2019. While this guidance provided more detail as to when a rental activity will be considered a trade or business, it excluded taxpayers utilizing triple net leases from the benefits of section 199A. When issuing the exclusion, the IRS defined a triple net lease as “a lease agreement that requires the tenant or lessee to pay taxes, fees and insurance, and to pay for maintenance activities for the property, in addition to rent and utilities.”
The verbiage in the guidance suggests that a landlord is not active in a business where the landlord performs maintenance but is reimbursed by the tenant. While this merely provides a safe harbor, it also supports that the IRS may take a more aggressive position with respect to a landlord’s active participation in the rental activity.
Another piece of legislation from TCJA provides the latest guidance with respect to the definition of a triple net lease. The Opportunity Zone (“OZ”) program was designed to foster investment in lower income communities. The OZ program offers tax deferrals and incentives to investors who invest in a qualified opportunity zone business (QOZB). To be a QOZB, the business must be an active trade or business within the designated zone. Once again, rental activities were left to ponder how their activities would be viewed.
The OZ regulations offer two examples regarding rental enterprises and triple net leases. For the OZ program, the IRS has returned to the more traditional and narrower definition of a triple net lease, i.e., a lease in which the tenant is responsible for paying all taxes, insurance and maintenance expenses. A rental enterprise will not be considered an active trade or business if the rental enterprise is merely a triple net lease. The example provided mirrors the one provided in the guidance from eleven years prior.
The OZ regulations depart from previous IRS guidance by providing an example of when a rental enterprise engaged in a triple net lease may be considered an active trade or business. In the example, the IRS demonstrates when a triple net lease combined with managerial and operational activities rise to the level of an active trade or business.
Company N constructs and places into service a new, three-story mixed-use building in a qualified opportunity zone and leases a floor to each of unrelated tenants X, Y and Z, respectively. This building is the only property owned by Company N. The lease agreement between Company N and tenant X is a triple net lease under which tenant X is responsible for all of the costs relating to the third floor of the building (for example, paying all such taxes, insurance and maintenance expenses) in addition to paying rent. The lease agreement between Company N and tenant Y is not a triple net lease and employees of Company N manage and operate the second floor of the building. Likewise, the lease agreement between Company N and tenant Z is not a triple net lease and employees of Company N manage and operate the first floor of the building. Company N maintains an office in the building, which the employees regularly use to carry out their managerial and operational duties with respect to the first and second floors and address any other issues that may arise with respect to the three leases.
While the above example still leaves plenty of questions for taxpayers in non-identical positions, it does provide more flexibility for taxpayers utilizing triple net leases in their rental activities to be deemed an active trade or business under the OZ program.
As demonstrated by the above, the definition of a triple net lease can change depending on the context of the IRS’s review. In practice, landlords and real estate professionals may use the term “triple net” for leases that do not meet the standards listed above. Consider, for instance, a lease in which the landlord is responsible for all structural repairs to real property while the tenant is responsible for non-structural repairs. The authorities discussed above simply provide insufficient guidance to decisively determine whether a landlord is active. As such, landlords are forced to balance the business desire to limit burdens of ownership with the tax risks associated with non-active rental activities.
We recommend taxpayers operating as landlords or real estate professional contact their Baker Tilly Advisor to determine whether they are operating an active trade or business with respect to any real estate holdings.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.