The taxation of passthrough income was among the many areas of tax law impacted by the Tax Cuts and Jobs Act. The Act introduced a new passthrough deduction that essentially lets individuals, trusts, and estates deduct up to 20% of their Qualified Business Income (QBI) for tax years beginning after December 31, 2017, and before January 1, 2026. Under a new safe harbor rule, rent and lease income may qualify for the Section 199A passthrough deduction.
Rental Real Estate Safe Harbor
The 199A deduction is only available for “qualified business income” arising from a “qualified trade or business.” QBI is the sum of qualified items of income, expenses, gains, and losses from a trade or business that is effectively connected to the conduct of business within the United States and included or allowed in determining taxable income. A qualified trade or business must be:
- considerable, regular, and continuous, and
- intended to make a profit.
Rental real estate activity that does not rise to the level of a trade or business under the existing tax code is nevertheless treated as a trade or business for purposes of Section 199A, and it can still produce qualified business income if it satisfies the safe harbor considerations outlined below. This means that there are now two methods to choose when determining if your rentals qualify for the new 20 percent deduction:
- Claim that the rental is a trade or business under existing law.
- Choose to use the new safe-harbor rules.
If you meet the new safe harbor for Section 199A, your rental is deemed a trade or business and net rental profits are considered qualified business income. Keep in mind that this safe harbor applies only to the Section 199A deduction and it does not qualify a rental enterprise as a trade or business for any other purpose.
Exclusively for the purposes of Section 199A, a rental enterprise will be treated as a trade or business if the following requirements are satisfied during the taxable year with respect to the rental enterprise:
- Separate books and records are maintained to reflect income and expenses for each rental enterprise.
- 250 or more hours of rental services are performed per year with respect to the rental enterprise.
- Taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, regarding the following:
(a) Hours of all services performed,
(b) Description of all services performed,
(c) Dates on which such services were performed,
(d) Who performed the services.
What is a 199A Rental Real Estate Enterprise?
A rental enterprise is an interest in real property held for production of rents. In simple terms, it is the ownership of the real estate for renting or leasing. The rental enterprise may consist of an interest in multiple properties. The owner must either:
- Treat each property as a separate enterprise, or
- Treat all similar properties as a single
Commercial and residential real estate may not be part of the same enterprise. Deciding whether to group the properties as a single enterprise, or to leave them as standalone enterprises, should take great consideration as taxpayers may not vary this treatment from year-to-year unless there has been a significant change in facts and circumstances.
For example: Bill owns five rental properties. Three of the properties are residential and two are commercial. Grouping allows Bill to have two real estate enterprises: one residential and one commercial.
Qualifying rental services for the purpose of this safe harbor 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, maintenance, and repair of the property,
- management of the real estate,
- purchase of materials,
- supervision of employees and independent contractors.
These aforementioned rental services may be performed by owners or by employees, agents, and/or independent contractors of the owners. Additionally, the term rental service does not include:
- financial or investment management activities, such as arranging financing, producing property, studying and reviewing financial statements or reports on operations,
- planning, managing or constructing long-term capital improvements, or
- hours spent traveling to and from the real estate.
Excluded Real Estate
While this deduction will benefit a vast majority of real estate investors, this safe harbor has also outlined certain rental real estate arrangements that are not eligible for the Section 199A deduction:
- Real estate used by the taxpayer as a residence, including vacation and second homes, for any part of the year.
- Triple net lease real estate, where a lease agreement requires the tenant or lessee to pay taxes, fees, and insurance, and to be responsible for maintenance activities for a property in addition to rent and utilities.
Safe Harbor Examples
Multi-family rentals, self-storage, and hospitality rental arrangements will often meet the requirements of the safe harbor. For multi-family rentals, property owners have various responsibilities and incur labor hours necessary to fulfill those responsibilities. Because the lease arrangements are not triple net lease, multi-family apartment rentals will fit within the scope of safe harbor requirements. Self-storage and hotels also have similar operating requirements and attributes as multi-family apartments in that the owner and the operator are the same. Therefore, it is likely that this type of asset class will meet safe harbor requirements.
In light of the significant requirements needed to meet this safe harbor and qualify for the Section 199A deduction, it is imperative that you keep well documented, contemporaneous records of all the relevant procedures. While it may not be easy getting to the safe harbor, once inside, there is comfort in knowing your rental properties qualify for the possible 20 percent tax deduction under Section 199A. Remember that you have a choice to use the following:
- Safe harbor as described in this article.
- Existing tax code trade or business rules to prove that your rental is a trade or business.
If you are considering using the new safe harbor, contact your tax advisor to discuss before making the choice between the two methods. At LBMC, we work with our clients to review and compare their rental enterprise activities to factors established by the IRS. We help them document their support when it comes to filing their tax return and taking the QBI deduction. If our client does not qualify for the deduction, we are able to analyze alternative structures that will bring value in the future.