New Deduction for Rental Property Owners
Section 199A and Rental Property
Under the Tax Cuts and Jobs Act (President Trump’s tax reform law), there was a new 20% Qualified Business Income (QBI) deduction. This deduction is a bit complicated in its application, but allows for a potential 20% deduction of business income, to include rental income.
So, if you are a rental property owner, it is important for you to understand this new law.
Note that while you may qualify for the deduction on your rental income based on the below information, there are taxable income limitations that may prevent you from actually claiming the deduction. The deduction starts to phase out at taxable income over $157.5K if filing Single/HOH and $315K for filing jointly.
Bob works full time at a bank and also owns 2 rental properties. He manages them himself. Is Bob eligible to take the 20% QBI deduction under Section 199A?
Answer: Yes, Bob is eligible but he may not qualify. Continue reading.
Is Real Estate “Qualified Business Property” for Section 199A?
Yes. Because all property subject to depreciation is “qualified property”, all net rental income, even if only one rental, is eligible for the 20% QBI deduction. The 20% QBI deduction does not differentiate between “passive” and “non-passive” business owners (§199A(b)(6)(A)).
The key word here is eligible. Bob is eligible for the QBI deduction, but now we need to see if he qualifies for the deduction.
The IRS issued a proposed revenue procedure in January 2019 (Notice 2019-07) that outlined a ‘safe harbor’ for a taxpayer’s real estate enterprise to qualify as a trade or business.
To qualify for Section 199A, the taxpayer’s rental real estate enterprise needs to meet the definition of a trade or business.
(Note that Section 199A does not require that a taxpayer ‘materially participate’ in a trade or business in order to qualify…which means that Bob can continue to report his rental on Schedule E (vs. Schedule C) and not be subject to self-employment tax on the net income.)
Rules to Qualify
Here are the rules to qualify as a trade or business under the safe harbor:
Keeping separate books and records to reflect income/expenses for each rental real estate enterprise.
Taxpayer(s) spend 250 or more hours per year performing ‘rental services’. Note they mean 250 hours for each rental.
Rental Services include:
- -advertising to rent or lease the real estate
- -negotiating and executing leases
- -verifying information contained in prospective tenant applications
- -collection of rent
- -daily operation
- -repair of the property
- -purchase of materials
- -supervision of employees and independent contractors
Rental services may be performed by owners or by employees, property managers, agents, and/or independent contractors of the owners.
Rental Services does not include financial or investment management activities such as:
-arranging financing; procuring property; studying and reviewing financial statements or reports on operations; planning, managing, or constructing long-term capital improvements
Rental Services does not include:
-hours spent traveling to and from the real estate
Taxpayer maintains records/a log recording:
- 1) Hours of all services performed
- 2) Description of all services performed
- 3) Dates on which such services were performed
- 4) Who performed the services
(Note the records/log requirement starts in 2019, not 2018)
So, if Bob believes that he qualifies under safe harbor he has to sign a statement affirming that he has followed all the rules above. This statement is attached to his tax return.
Now here is the tricky part…
The proposed regulation outlining the safe harbor detailed above also states this:
“Failure to satisfy the requirements of this safe harbor does not preclude a taxpayer from otherwise establishing that a rental real estate enterprise is a trade or business for purposes of section 199A.”
So a taxpayer’s rental real estate may still qualify as a trade or business for purposes of Section 199A, EVEN IF THE TAXPAYER DOES NOT QUALIFY UNDER THE SAFE HARBOR.
So how does the IRS define ‘trade or business for 199A in terms of rental property outside of the safe harbor? The IRS issued final regulations on this in January 2019.
On page 12 they state that they will use Internal Revenue Code Section 162 to define ‘trade or business’.
So what does Section 162 say? Well, unfortunately not much, as it defines business owners can deduct ordinary and necessary expenses.
Okay, so now what? What it seems the IRS really means is that the rental enterprise activities must be regular, continuous and with a profit motive…and they will likely look to previous rulings and court cases to help define the definition of a trade or business.
They also say:
“In determining whether a rental real estate activity is a section 162 trade or business, relevant factors might include, but are not limited to (i) the type of rented property (commercial real property versus residential property), (ii) the number of properties rented, (iii) the owner’s or the owner’s agents day-to-day involvement, (iv) the types and significance of any ancillary services provided under the lease, and (v) the terms of the lease (for example, a net lease versus a traditional lease and a short-term lease versus a long-term lease).”
So what do we think?
I think if Bob claims his real estate enterprise to be a trade or business, and truly qualifies under the safe harbor he will be okay. This is assuming he keeps a very detailed log of all work performed and follow to a ‘T’ all rules listed above.
If Bob thinks he qualifies, but not under safe harbor, he may have a harder time winning an audit. He would still need to keep very detailed records and we recommend that under either (safe harbor or Section 126) he should do the minimum:
- -Have a separate bank account for each property.
- -Maintain separate books/records for each property.
- -Keep a detailed log of all time spent by you or agents/employees/contractors.
- -File forms 1099 each January for any contractors that you pay $600 or more to for services (1099’s are required for active business and further support ‘active trade or business’). Make each contractor fill our Form W-9 before starting any work (this has all the info you need to issue the 1099).
- -In addition, the rental activities must be regular, continuous and with a profit motive.
In conclusion, there is no bright line test, but I don’t think it makes the determination all that difficult.
Most taxpayers after reading this summary should be able to look at how they manage their rental real estate and determine if they qualify within the law.
The hard/tedious part for you (the taxpayer) is going to be documenting all the management time so that the IRS will be convinced as well.