199A Deduction for Rental Real Estate Investors
Unless you’ve been hiking through the Amazon jungle for the past year, you have most certainly heard about the Tax Cuts and Jobs Act (effective January 1, 2018). Furthermore, if you own a small business or own real estate, the topic of the 199A or 20% pass-through deduction has crossed your mind, or at least your email.
This little gem called the 199A Pass Through is a 20% deduction off the bottom line profit of your business, but also comes with a lot of twists and turns and complexity. In fact, many don’t realize it also applies to rental property. That’s right! If you’re a landlord and have net rental income, you may qualify for one of the best tax benefits from the TCJA tax reform.
Rental Real Estate under the New Law
When the 199A was first passed, tax professionals didn’t think it would apply to passive income from holding rental property. The Section 199A only applied to “Qualified Business Income” (QBI), which was generally defined as income from a qualified trade or business other than a specified service trade or business or the performance of services as an employee. Sounds simple and straightforward on the face of it, right?
Well as we know, the devil is in the details and so it was up to tax professionals and lawyers to interpret the law, while at the same time the lobbyists went to work on Washington and the IRS started to propose Regulations. Was rental real estate a “Qualified Business”?
Even though prior court decisions had already confirmed that rental properties qualified as a trade or business, there was some uncertainty as to whether the IRS would extend the definition of QBI to include income from rental properties.
In response, the IRS recently released Notice 2019-7 (“Notice”) in January of 2019, which provides guidance with respect to how the IRS will apply the 199A deduction to rental activities. Essentially, the IRS proposed certain rules establishing a “Safe Harbor” by which rental activities will qualify for the 199A deduction.
The “Safe Harbor” Test
In order for a rental property, or one might say a “rental business’ to qualify as Qualified Business Income, and thus qualify for the Safe Harbor provision allowing the 199A deduction, the taxpayer must meet the following requirements:
1. Separate Enterprise Rule. Taxpayers must either treat each rental property as a separate enterprise or treat similar rental properties as a single enterprise. The Notice is clear that commercial and residential real estate cannot be in a single enterprise, but it appears that similar residential properties can be in a single enterprise. Once the enterprises have been established, they cannot be varied unless there has been a significant change in circumstances.
2. Separate Books. For each ‘Separate Enterprise’ (meaning group of rental properties), there must be separate books and records maintained to reflect income and expenses for each enterprise. Frankly, this is a no-brainer and simple for any rental property owner because they should be maintaining their books with QuickBooks and each group of rentals could very well be in a Limited Liability Company (LLC).
3. 250 or more hours of “Rental Services”
For each Separate Enterprise, there must be 250 hours of rental services performed. Again, think of 3-4 residential rentals in one LLC qualifying as an ‘enterprise’ (approximately 5 hours/week). Rental Services includes:
· advertising to rent or lease the real estate,
· negotiating and executing leases,
· verifying information contained in prospective tenant applications,
· collection of rent,
· daily operation, maintenance, and repair of the property,
· management of the real estate,
· purchase of materials,
· supervising employees and independent contractors.
The Notice confirms that “Rental Services” may be performed by owners, or by employees, agents, and/or independent contractors of the owners. However, specifically excluded from the Safe Harbor are real estate rented under a triple net lease (generally leases where tenants accept responsibility to pay taxes, fees, insurance or Common Area Maintenance (CAM)).
The Notice provides that the following do NOT constitute “Rental Services” for this section which include:
· Financial or investment management activities (arranging financing),
· Procuring Property,
· Studying and reviewing financial statements or report on operations,
· Planning, managing or constructing long term capital improvements, or
· Hours spent traveling to and from the real estate.
4. Additional Record Keeping. In addition to financial records or ‘books’, Taxpayer must maintain “contemporaneous” records, including time reports, logs, or similar documents regarding: (i) dates, hours and description of services performed and (ii) who performed the services. This contemporaneous records requirement applies beginning in 2019. That means if you want to comply with the safe harbor provisions, you need to keep these records at the time it is happening.
5. Signed Statement. The Notice also requires that a taxpayer claiming the deduction must sign a statement under penalty of perjury that the requirements set forth in the Notice have been satisfied.