As the IRS continues to release guidance on the new 20 percent deduction, it is prudent to determine sooner rather than later if your rental real estate is eligible for the QBI deduction.
As we advised in our recent 2019 Year-End Tax Planning Guide, if you own rental real estate, your activities may qualify for the new 20 percent Qualified Business Income (QBI) deduction. Under guidance issued by the IRS, rental real estate is eligible for the QBI deduction if you can (1) claim the rentals are trades or businesses under existing law, or (2) use the new safe harbor rules. New Section 199A allows you to claim a deduction against your taxable income of up to 20 percent of your qualified business income. These new rules can provide significant tax savings, so we urge you to read further.
In order to qualify for the safe harbor, you must keep separate books and records for the activity; perform 250 or more hours of rental services per year; and maintain reports, logs or similar documents that show the hours of all services performed, a description of all services performed, the dates on which the services were performed and who performed the services. If you do not meet these requirements, it is still possible that your rental activities qualify for the deduction as a trade or business under existing law. The IRS has recently finalized regulations related to the safe harbor with a few new twists, which we describe further below.
The safe harbor is available to taxpayers who seek to claim the QBI deduction with respect to a rental real estate enterprise as defined under “Rental Real Estate Enterprise” below. If the safe harbor requirements are met, the rental real estate enterprise will be treated as a single trade or business for purposes of applying the regulations.
A relevant pass-through entity (RPE) may also take advantage of the safe harbor. Such entities include partnerships (other than a publicly traded partnership) or S corporations owned, directly or indirectly, by at least one individual, estate or trust.
In order to rely upon the safe harbor, taxpayers and RPEs must satisfy all of the requirements set forth by the IRS in Revenue Procedure 2019-38. Failure to satisfy the requirements of this safe harbor does not necessarily preclude a taxpayer or IRS from otherwise establishing that an interest in rental real estate is a trade or business, but failure certainly makes the determination more difficult.
Rental Real Estate Enterprise
Solely for purposes of the safe harbor, a rental real estate enterprise is defined as an interest in real property held for the production of rents and may consist of an interest in a single property or interests in multiple properties. The taxpayer or RPE must hold each interest directly or through a disregarded entity, which, for tax purposes, is an entity not recognized separately from its owner. For example, if a taxpayer owned one residential rental real estate property individually and owned another residential rental real estate property through an LLC owned 100 percent by the taxpayer, then the two properties would be eligible to be combined into a single rental real estate enterprise. However, if the taxpayer’s LLC in the preceding example had multiple members, then the two properties would not be eligible to be combined into a single rental real estate enterprise.
Except for those property interests described under “Excluded Real Estate Arrangements” below, taxpayers and RPEs may either treat each interest in similar property held for the production of rents as a separate rental real estate enterprise or treat interests in all similar properties held for the production of rents as a single rental real estate enterprise. Properties held for the production of rents are similar if they are part of the same rental real estate category.
What are the two types of rental real estate categories for the purpose of combining properties into a single rental real estate enterprise? If you guessed residential and commercial, you are correct! Thus, commercial real estate held for the production of rents may only be part of the same enterprise with other commercial real estate, and residential properties may only be part of the same enterprise with other residential properties.
Once a taxpayer or RPE treats interests in similar commercial properties or similar residential properties as a single rental real estate enterprise under the safe harbor, the taxpayer or RPE must continue to treat interests in all similar properties, including newly acquired properties, as a single rental real estate enterprise when the taxpayer or RPE continues to rely on the safe harbor. However, a taxpayer or RPE that chooses to treat its interest in each residential or commercial property as a separate rental real estate enterprise may choose to treat its interests in all similar commercial or all similar residential properties as a single rental real estate enterprise in a future year.
An interest in mixed-use property (a single building that combines residential and commercial units) may be treated as a single rental real estate enterprise or may be bifurcated into separate residential and commercial interests.
The Safe Harbor
The determination to use this safe harbor must be made annually. Each rental real estate enterprise will be treated as a single trade or business if the following requirements are satisfied during the tax year with respect to the rental real estate enterprise:
- Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise. If a rental real estate enterprise contains more than one property, this requirement may be satisfied if income and expense information statements for each property are maintained and then consolidated;
- For rental real estate enterprises that have been in existence less than four years, 250 or more hours of rental services are performed (as described in more detail below) per year with respect to the rental real estate enterprise. For rental real estate enterprises that have been in existence for at least four years, in any three of the five consecutive tax years that end with the current tax year, 250 or more hours of rental services are performed per year with respect to the rental real estate enterprise;
- The taxpayer maintains contemporaneous records, including time reports, logs or similar documents, regarding the following: (i) hours of all services performed; (ii) description of all services performed; (iii) dates on which such services were performed; and (iv) who performed the services. Services may be performed by employees or independent contractors, provided the taxpayer maintains descriptions of the rental services performed by such employee or independent contractor, including time spent as well as wage and payment records for such employee or independent contractor.
Rental services can include advertising to rent the real estate, negotiating/executing leases, verifying tenant application information, collecting rent, rental property maintenance/management, purchasing materials and/or supervising employees or independent contractors. It is also important to note certain rental services that do not qualify under the safe harbor include: financial or investment management activities (arranging financing, procuring property or studying financial statements), planning, managing or construction of long-term capital improvements and time spent traveling to and from the rental property.
- The taxpayer or RPE attaches a statement to a timely filed original return (or an amended return for the 2018 tax year only) for each tax year in which the taxpayer or RPE relies on the safe harbor, which must include both a description (including the address and rental category) of rental real estate properties acquired and disposed of during the tax year and a representation that the requirements of the safe harbor rules have been satisfied.
Excluded Real Estate Arrangements
Certain types of property may not be included in a rental real estate enterprise and are therefore not eligible for the safe harbor. These include:
- Real estate used by the taxpayer (including an owner or beneficiary of an RPE) as a residence;
- Real estate rented or leased under a triple net lease;
- Real estate rented to a trade or business conducted by a taxpayer or an RPE; and
- The entire rental real estate interest if any portion of the interest is treated a specified service trade or business, such as law firm, accounting firms and the like.
As the IRS continues to release guidance on the new 20 percent deduction, it is prudent to determine sooner rather than later if your rental real estate is eligible for the QBI deduction. By investing a little time now, you may discover a new and significant tax-saving opportunity to reduce your tax payments due in January 2020 and/or in 2020 when your file your 2019 tax returns. As with any new and developing tax deduction, we are available to discuss whether you qualify and the implications to your personal or business tax matters.
For Further Information
If you would like more information about this topic or your own unique situation, please contact Luke J. Bartlinski, CPA, Steven M. Packer, CPA, Michael A. Gillen or any of the practitioners in the Tax Accounting Group. For information about other pertinent tax topics, please visit our publications page.
Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.