When the Tax Cuts and Jobs Act signed into law in 2017, the act brought changes to both personal and business income taxes. We developed a comprehensive guide on the TCJA and offered more details on the Qualified Business Income Deduction (QBDI) in 2018, but questions still remain on some of the finer details, particularly with rental properties. In a competitive rental market like the Madison area, you’re likely wondering if your rental property income qualifies for the coveted 20% tax deduction.
The IRS recently clarified and issued some guidance on whether income from real estate rental activities was “Qualified Business Income” (QBI). Notice 2019-07, a new proposed revenue procedure, provides a safe harbor under which rental real estate will be treated as a trade or business solely for the purposes of Section 199A. This proposed revenue procedure would apply to tax years ending after December 31, 2017. The new notice, however, does not apply to self-rental situations, where a business pays rent to a related party entity which is owned by the same business owner(s). We’ll outline some of the core details from the IRS notice and how to qualify, below.
Qualifying for the Safe Harbor
Taxpayers looking to utilize Section 199A’s deduction must hold the rental property directly or through a disregarded entity. They must also treat each rental property as a single activity or elect to treat all similar rentals as a single activity. The choice is either a “one or all,” meaning you must combine all similar rentals, or treat all similar rentals separately. It’s also important to note that residential and commercial rentals cannot be combined into a single activity. Taxpayers must be consistent with this year-to-year, unless they can show a significant change in facts and circumstances.
To qualify for the safe harbor, under Notice 2019-07, the owner of a rental activity will have to meet the following requirements during the taxable year:
- Maintain separate books and records for each rental activity.
- For taxable years beginning prior to 1/1/2023, 250 or more hours of “rental services” are performed per year with respect to the rental activity. For taxable years beginning after 12/31/2022, any three of five consecutive taxable years that end with the taxable year, 250 hours are performed with respect to the rental activity.
- Maintain contemporaneous records, including time reports, logs, or similar documents, regarding the following:
- Hours of all services performed.
- Description of all services performed.
- Dates on which the services were performed.
- Who performed the services.
Such records are to be available to the IRS in case of an audit. This documentation requirement will not apply to tax years beginning prior to 1/1/2019.
What is and is not included in “Rental Services?”
“Rental Services” include:
- Advertising to rent the property.
- 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.
- Purchases of Materials.
- Supervision of employees and independent contractors.
The “rental services” can be performed by owners, employees, agents, or independent contractors of the rental enterprise.
“Rental services” do not include financial or management activities such as:
- Arranging financing.
- Procuring property.
- Studying or reviewing financial statements or reports on operations.
- Planning, managing, or constructing long-term capital improvements.
- Hours spent driving to and from the real estate.
Also, there are several other situations that do not qualify for this safe harbor:
- Real estate use by the taxpayer as a residence for any part of the year.
- Real estate rented under a triple net lease.
Lastly, a taxpayer must attach a statement to their tax return that states they have met the requirements of the safe harbor. Writing the statement correctly is important, so be sure to reference the IRS website or get advice from a tax professional to ensure you have the best chances of receiving the 20% deduction.
It’s also important to note that this is a safe harbor, which means that the taxpayer who meets the criteria can claim the rental income as QBI. If the taxpayer does not meet the safe harbor criteria, the rental income may still qualify as QBI if it meets the definition of a trade or business.
Do you have a rental property and wish to take advantage of this new deduction? Schedule a meeting with us and we’ll strategize the best options for you and your business.