In December of 2017, the Tax Cuts and Jobs Act was signed into law, which created IRS code section 199A, the Qualified Business Income Deduction. While the details of the code are inexhaustible, for our purpose it is only important to understand the basic nature of the 199A deduction. In a sentence, the 199A deduction is a potential 20% phantom deduction from your trade or business income. For example, if your business makes $100,000 in a year, the business may be entitled to a $20,000 phantom deduction and pay tax on only $80,000, provided the business meets certain limitations. This is a sizable tax break for owners of trades and businesses. However, the IRS generally does not consider a rental property to be a trade or business. Therefore, owners of residential or commercial rental properties would generally not qualify for this new deduction. But in January of 2019, the IRS released Notice 2019-07, which institutes a safe harbor for rental real estate owners who may otherwise not be able to take the 199A deduction. Notice 2019-07 applies to individuals, pass-through entities, and disregarded entities.
Before we discuss how to qualify under the safe harbor, let’s review a few types of rentals Notice 2019-07 does not cover. Triple-net leases are not eligible for this safe harbor. In a triple net lease, the tenant or lessee pays for taxes, fees, insurance, and is responsible for maintenance. The IRS argues that you cannot be active in such a scenario. Additionally, if you use a rental property as a personal residence for more than 14 days during the taxable year, you will not qualify for the safe harbor. Finally, if your rental property is leased by a company that you own, the safe harbor is not necessary to use because the rental activity is considered to be a part of the trade or business for purposes of section 199A. If none of these scenarios apply, you are likely eligible for the safe harbor, so long as the following three qualifications are met.
- You must have at least 250 hours of rental services performed for each Rental Real Estate Enterprise. A Rental Real Estate Enterprise is defined by the IRS as “an interest in real property held for the production of rents and may consist of an interest in multiple properties.” The phrase “multiple properties” is important because you can consider your entire residential rental portfolio as a single enterprise. The 250-hour test can be aggregated amongst all rental properties, making it considerably easier to meet the limitations. The only restrictions on aggregation are: you cannot vary the treatment of aggregation year-to-year, and commercial rental and residential rental must be considered as separate enterprises, and not co-mingled.
What activities qualify for the 250 hours of rental services? Below is a list provided by the IRS:
- Negotiating and executing leases
- Reviewing and verifying tenant applications
- Collection of rent
- Daily operation, maintenance, repairs
- Purchase of materials
- Supervision of employees and contractors
- Fortunately, you do not have to perform all these activities. These services can be performed by the owner, employees, agents, or independent contractors, which again makes this test easier to meet.
- How does the IRS know these services were performed? The second test is keeping contemporaneous records. These records should include hours worked, a brief description of the service performed, the date of the service, and who performed the service. Again, these records should be kept contemporaneously. Keep a logbook when you are making your rounds, or have an employee send you an email or text so you can log their hours.
Lastly, separate books and records must be maintained for each Rental Real Estate Enterprise. You must have a good set of financial data to substantiate your income and expenses. It is also imperative that you file any necessary 1099s. Remember, you are asserting you are a trade or business. Proper reporting is paramount to substantiate that assertion.
- You have now met all the qualifications to qualify under the safe harbor provisions of Notice 2019-07, congratulations! But how is the safe harbor election made on your tax return? The return must include a statement that all qualifications have been met. The statement must be signed and dated under penalties of perjury and filed with your return. Fortunately, the IRS produced a statement form that can be signed and attached to the return. This election must be made annually.
Every rental situation is unique and could require additional planning. If you have any questions regarding the application of this notice, or how it relates to the new tax law, please do not hesitate to give us a call. We enjoy walking through these scenarios with our clients.
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