Real Estate Wins Again: IRS Clarifies Deduction for Rental Activities
Can you take the 20% qualified business income (QBI) deduction against income from rental properties? The Tax Cuts and Jobs Act said no deduction is allowed for “mere” investment in real estate, but where is the line between investment and an active real estate business? In response to uncertainty expressed by taxpayers, the IRS has confirmed that a rental real estate activity may be considered an eligible trade or business under Sec. 199A. In fact, if taxpayers follow the IRS’s three new rules, the deduction is essentially guaranteed. A proposed revenue procedure offers this “safe harbor” treatment and explains what taxpayers need to do to prove their rentals qualify.
Rental Real Estate Enterprise Defined
The IRS defines a “rental real estate enterprise” as an interest in real property held for the production of rents, which may consist of multiple properties. A taxpayer or eligible passthrough entity must hold the interest directly or through a disregarded entity. “Relevant passthrough entities” (RPEs) also may use the safe harbor. An RPE is a partnership or an S corporation that is owned, directly or indirectly, by at least one individual, estate, or trust.
Forget taking the deduction for rental of your beach house, however. Property used by the taxpayer as a residence for any part of the year is not eligible under the proposed safe harbor. Also, property subject to a triple-net lease will not qualify for the QBI deduction because the real estate will be considered a passive investment.
Taxpayers also must either treat each property as a separate enterprise or treat all similar properties as a single enterprise. Commercial and residential real estate may not be part of the same enterprise. Taxpayers may not vary this treatment from year-to-year unless there has been a significant change in circumstances.
Three Criteria for Safe Harbor
To satisfy the safe harbor, the rental enterprise must comply with the following three rules:
- Maintain separate books and records to reflect income and expenses for each rental real estate enterprise;
- Perform 250 or more hours of rental services per year for now through 2022. After 2022, the taxpayer only needs to do 250 hours of rental services for three out of five years; and
- Maintain contemporaneous records, including time reports, logs, or similar documents, on (i) hours of all services performed; (ii) description of all services performed; (iii) dates on which the services were performed; and (iv) who performed the services. This requirement does not apply to taxable years beginning before January 1, 2019.
By “contemporaneous”, the IRS means the service hours should be logged at the time they are completed. Recreating logs at a later time is not wise. The IRS will deny the deduction if a taxpayer does not produce what it considers as contemporaneous logs.
Qualifying Rental Services
A key to qualifying for the safe harbor is completing the 250 hours of rental services per year. This requirement is made easier by the fact that rental services may be performed by persons other than the owners, including employees, agents, and independent contractors. However, if each property is a separate enterprise, it may be more difficult to log the requisite number of hours.
Qualifying rental services 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
An owner’s financial or investment management activities will not count toward the 250 hours. Tasks like arranging financing, procuring property, reviewing financial statements or reports on operations, managing long-term capital improvements, or hours spent traveling to and from the real estate do not qualify as rental activities.
No Safe Harbor, No Problem…Maybe
The revenue procedures note that taxpayers who do not meet the safe harbor requirements for rental activities still have the opportunity to “prove” that they are engaged in a rental real estate business. The problem is that the burden of proof will be on the taxpayer to demonstrate that they are engaged in a rental trade or business. The safe harbor creates a presumption that the taxpayer is engaged in a qualified rental activity.
Given the key to qualifying for the deduction is the threshold number of rental activity hours rental business owners should evaluate whether it makes sense to combine similar properties into one enterprise. This will make it easier to hit the 250-hour threshold, but it may be less desirable for other, non-tax reasons. Also, it remains to be seen what the IRS considers “similar properties”.
For now, the certainty provided by the revenue procedure is a welcome change that rewards taxpayers who keep good records and who put in the time and thought necessary to check each box for the safe harbor requirements.