Under section 199A, a new provision of federal tax law under the Tax Cuts and Jobs Act of 2017, taxpayers may deduct up to 20% of their qualified business income when calculating taxable income. The new law and subsequent regulation were unclear, though, on whether income from rental real estate qualified for the deduction.
Aware of the problem, the IRS issued additional guidance on rental real estate on January 18, 2019, in the form of a proposed revenue procedure in Notice 2017-07. Taxpayers may use the proposed rules until the official rules are finalized later this year.
The requirements in the notice provide a “safe harbor” for taxpayers wanting to claim a section 199A deduction for their rental real estate income. This means that if the requirements are met for rental real estate, the IRS will consider it a “trade or business,” which would allow it to qualify for the deduction. However, even if the rental real estate doesn’t meet the requirements of the notice, it may still qualify as a trade or business under the definitions contained in Treasury regulations. The safe harbor requirements provide just one way for taxpayers to determine if they are allowed to take the deduction.
The Most Critical Requirement
The most important requirement is that 250 hours or more of “rental services” be performed for each rental “enterprise.” The 250-hour requirement is for tax years through 2022. Beginning in 2023, rental services of 250 hours or more must be performed in three of five consecutive tax years.
A rental enterprise can be a single property or multiple properties. Taxpayers can choose how to group their properties into rental enterprises, keeping in mind that each rental enterprise must meet the safe harbor requirements individually.
For example, a family that owns and rents six single-family homes could treat all six together as one rental enterprise, could treat each as a separate rental enterprise, or could group two properties into one rental enterprise and group four into a second enterprise, perhaps based on how close the properties are to one another.
Because the 250-hour requirement applies to each separate rental enterprise, it may make sense to combine multiple properties into a rental enterprise if it’s difficult to meet the requirement with a single property.
Property Grouping Considerations
There are a few further considerations for property groupings. Commercial and residential property cannot be part of the same rental enterprise, so real estate owners with both types of property will need to have two rental enterprises at a minimum.
Also, separate books and records must be maintained for each rental enterprise—i.e., you must have separate accounting and financial statements for each.
Additionally, the groupings must remain constant from year to year unless there has been “a significant change in facts and circumstances,” which the notice doesn’t define.
What Counts and Doesn’t Count Toward the 250 Hours
“Rental services” that count toward the 250-hour requirement for each rental enterprise include:
Advertising to rent or lease the real estate
Negotiation and execution of leases
Verification of 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
Rental services that count toward the 250-hour requirement specifically do not include financial or investment management activities, such as:
Studying and reviewing financial statements or reports on operations
Planning, managing, or constructing long-term capital improvements
Hours spent traveling to and from the real estate
This seems to indicate that working with real estate agents to identify new investment properties and working with mortgage brokers and banks to line up financing do not count toward the requirement.
Presumably, the idea is that “rental services” must include only activities required to operate the real estate business and not include activities related to making a real estate investment. Related to this idea, triple net leases, which shift much of the management responsibility from landlord to tenant, are specifically excluded from this safe harbor.
Rental services may be performed by owners or by employees, agents, and independent contractors of the owners. The rules require that taxpayers keep “contemporaneous” records, which involves keeping track of the hours spent and services performed at the time services are performed (as opposed to, for example, estimating hours at year-end in preparation for tax filing).
Taxpayers should keep records of the following:
Hours of all services performed
Description of services performed
Dates on which services were performed
Who performed the services
Because this notice of safe harbor was not published until 2019, the record-keeping rules do not apply to 2018. But beginning January 1, 2019, taxpayers wanting to use this safe harbor to claim the section 199A deduction must keep these contemporaneous records.
It appears that in addition to documenting their own rental service hours, property owners will also need to require all their service providers—from property managers to handymen—to do the same.
A Safe Harbor Statement Required
One note of caution in using the safe harbor: The notice rules require that taxpayers include a statement with their tax return saying that they have followed the safe harbor rules. The statement must be signed under penalty of perjury—a felony with serious penalties, including fines and up to five years in prison.
Because this is a new and complex area of tax law, it’s a good idea to consult with your tax advisor about whether you qualify for the section 199A deduction for rental real estate and whether making use of this safe harbor is a good idea in your particular situation.
You can read more on the rental real estate safe harbor in the IRS press release announcing it and in other updates on section 199A.
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