Unless you’ve been hiking through the Amazon jungle for the past year, you have most certainly heard about the Tax Cuts and Jobs Act (effective January 1, 2018). Furthermore, if you own a small business or own real estate, the topic of the 199A or 20% pass-through deduction has crossed your mind, or at least your email.
This little gem called the 199A Pass-Through is a 20% deduction off the bottom line profit of your business, but also comes with a lot of twists and turns and complexity. In fact, many don’t realize it also applies to rental property. That’s right! If you’re a landlord and have net rental income, you may qualify for one of the best tax benefits from the TCJA tax reform.
Rental Real Estate under the New Law
When the 199A was first passed, tax professionals didn’t think it would apply to passive income from holding rental property. Section 199A only applied to “Qualified Business Income” (QBI), which was generally defined as income from a qualified trade or business other than a specified service trade or business or the performance of services as an employee. Sounds simple and straightforward on the face of it, right?
Well as we know, the devil is in the details and so it was up to tax professionals and lawyers to interpret the law, while at the same time the lobbyists went to work on Washington and the IRS started to propose Regulations. Was rental real estate a “Qualified Business”?
Even though prior court decisions had already confirmed that rental properties qualified as a trade or business, there was some uncertainty as to whether the IRS would extend the definition of QBI to include income from rental properties.
In response, the IRS released Notice 2019-7 (“Notice”) back in 2019, which provides guidance with respect to how the IRS will apply the 199A deduction to rental activities. Essentially, the IRS proposed certain rules establishing a “Safe Harbor” by which rental activities will qualify for the 199A deduction.
The “Safe Harbor” Test
In order for a rental property, or one might say a “rental business” to qualify as Qualified Business Income, and thus qualify for the Safe Harbor provision allowing the 199A deduction, the taxpayer must meet the following requirements:
- Separate Enterprise Rule. Taxpayers must either treat each rental property as a separate enterprise or treat similar rental properties as a single enterprise. The Notice is clear that commercial and residential real estate cannot be in a single enterprise, but it appears that similar residential properties can be in a single enterprise. Once the enterprises have been established, they cannot be varied unless there has been a significant change in circumstances.
- Separate Books. For each ‘Separate Enterprise’ (meaning group of rental properties), there must be separate books and records maintained to reflect income and expenses for each enterprise. Frankly, this is a no-brainer and simple for any rental property owner because they should be maintaining their books with QuickBooks and each group of rentals could very well be in a Limited Liability Company (LLC).
- 250 or more hours of “Rental Services”
For each Separate Enterprise, there must be 250 hours of rental services performed. Again, think of 3-4 residential rentals in one LLC qualifying as an ‘enterprise’ (approximately 5 hours/week). Rental Services include:
- advertising to rent or lease the real estate,
- negotiating and executing leases,
- verifying the 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,
- supervising employees and independent contractors.
The Notice confirms that “Rental Services” may be performed by owners, or by employees, agents, and/or independent contractors of the owners. However, specifically excluded from the Safe Harbor is real estate rented under a triple net lease (generally leases where tenants accept responsibility to pay taxes, fees, insurance, or Common Area Maintenance (CAM)).
The Notice provides that the following do NOT constitute “Rental Services” for this section which include:
- Financial or investment management activities (arranging financing),
- Procuring Property,
- Studying and reviewing financial statements or report on operations,
- Planning, managing, or constructing long-term capital improvements, or
- Hours spent traveling to and from the real estate.
- Additional Record Keeping. In addition to financial records or ‘books’, taxpayers must maintain “contemporaneous” records, including time reports, logs, or similar documents regarding (i) dates, hours, and description of services performed and (ii) who performed the services. The requirement for this contemporaneous record started in 2019. That means if you want to comply with the safe harbor provisions, you need to keep these records at the time it is happening.
- Signed Statement. The Notice also requires that a taxpayer claiming the deduction must sign a statement under penalty of perjury that the requirements set forth in the Notice have been satisfied.
Interestingly, the Notice is also clear that although a taxpayer may fail to satisfy these ‘safe harbor’ requirements, it doesn’t necessarily preclude a finding that the rental income qualifies as QBI if other requirements for defining a trade or business in the regulations are satisfied. I presume this means that ongoing cases and IRS Notices in the future will set forth scenarios where taxpayers with rentals still qualify for the 199A deduction even though they didn’t jump through the hoops of the Safe Harbor provisions.
Again, prior court cases have confirmed that income from a trade or business generally includes income from a rental property. However, landlords who anticipate taking the 199A deduction for their rental properties are advised to structure their activities and record-keeping to follow these Safe Harbor provisions to ensure eligibility for this tax benefit.
Watch out for the IRS and their Motivation
I actually believe a taxpayer that owns rentals has to be very very careful and strategic on how they approach the 199A Deduction. In fact, I strongly urge you to NOT simply pursue the 199A without considering the ramifications. Here’s why…
What do rental properties generally produce on your tax return? Losses. That’s right, losses from write-offs such as deprecation, mortgage interest, and other direct as well as indirect expenses can be a huge strategy for real estate investors.
In fact, one might argue that the 199A Deduction is irrelevant for the far majority of rental property investors. If they don’t have a ‘gain’ from the rental income, there isn’t even a 20% deduction to be had anyway.
However, I’m actually very worried by this recent Notice and the IRS wanting or allowing rental income to be classified as Qualified Business Income. See, when a taxpayer does it’s calculations to take the 199A Deduction, they MUST include ALL of their QBI income AND losses before they calculate the 20% write-off. So IF the rental properties are treated as qualified trade or business, and generally lose money on paper, the IRS is highly motivated to classify the taxpayer’s rental enterprise as QBI. Result- Your rental losses inadvertently reduce your 199A Deduction on your other business income! This would be a terrible outcome.
The IRS makes you jump through hoops TO classify your rental ‘income’ as QBI, if you want it to be QBI and get the 20% deduction…but if you don’t want it to be QBI, it’s in IRS’s best interest to classify it as QBI when you have a loss and reduces your 20% deduction. They will surely twist the definitions and interpretation of this law to fit their needs based on the circumstances. So should you! This is why I think the IRS stated in the Notice that even if a taxpayer doesn’t meet the safe harbor tests “it doesn’t necessarily preclude a finding that the rental income qualifies as QBI”.
What is the Ultimate Strategy for a Taxpayer?
- If you have rental losses, you DO NOT want your enterprise to be considered QBI and included in the 199A Deduction calculation, BUT you (or your spouse) DO want to be considered a real estate professional in order to deduct the losses against your other ordinary income.
- If you have net rental income, you DO want the enterprise to be considered QBI in order to receive the 199A Deduction, but still consider the income passive and not subject to self-employment tax.
Your tax advisor needs to be keenly aware of what strategy is best for you in your situation and exploit it. One mistake in classifying your business, enterprise, income, or whatever you want to call it, incorrectly and the ramifications on your tax bill will certainly be in the thousands.
Bottom line, you don’t have to be an expert on the topic, but simply be aware of the issues and be able to carry on an intelligent strategic conversation with your tax advisor. Remember, it’s just as important to save money, as it is to make money and taxes are one of the greatest areas to save if you approach it properly.
