This has to be the most frequent question I receive on the Tax Cuts and Jobs Act Section 199A, commonly referred to as the Qualified Business Income (QBI), deduction!
I wish I’d had a simple answer, but I often did not. The new law (the TCJA) and the Proposed Regulations for Section 199A were silent on this subject, referring us only to IRC Section 162. Section 162 doesn’t, itself, give a definition for a trade or business, so we turned to case law for individual answers.
But this weekend we got some relief! On Friday, January 18, 2019, the Treasury Department issued Final Regulations for 199A and IRS Notice 2019-07, which provided a safe harbor for rental real estate enterprises. Rental activities that meet each of the following tests can be considered Section 162 trades or businesses for purposes of Section 199A, and are thus eligible for the 20 percent deduction.
A real estate investor needs to do three things to meet this safe harbor:
- The taxpayer, an employee, an agent, and/or an independent contractor must spend at least 250 hours performing “rental services”. (Starting in 2023, that test needs only to be met three of the previous five years). Rental services involve advertising to rent, negotiating and executing leases, collecting rent, verifying tenant applications, daily operation, repairs and maintenance, purchasing materials, and supervising employees and contractors. It won’t count financing activity, procurement of property, reviewing financials, or time spent traveling.
- Separate books and records, reflecting income and expenses, must be kept for each rental activity or group of activities.
- Beginning in 2019, owners must keep a contemporaneous record of rental services including: Hours of services performed, a description of the services, dates on which such services are performed, and who performed the services. Thankfully, this is not required for 2018 tax filings.
Taxpayers can treat each property as a separate enterprise or can treat all similar properties held for rent as a single enterprise. There are a few stipulations: the treatment of grouped properties must be consistent from year to year; commercial and residential rentals can’t be co-mingled; and triple net leases and properties that the owner or beneficiary used as a personal residence for part of the year don’t qualify for the safe harbor.
The Final Regulations left in place the self-rental rule. What does that mean? Basically, if you have rental real estate that is leased to a commonly controlled flow-through entity (one with 50 percent or more common ownership), the rental activity will be treated as a Section 162 trade or business. This occurs whether the rental activity rises to the level of a Section 162 business on its own accord.
The safe harbor will provide many rental activities with a clear “yes” answer to the question of whether they qualify for the Section 199A deduction, but some rental activities won’t meet all the requirements.
The Treasury department very clearly tells us that just because you don’t meet the safe harbor does not mean your rental activity is not a Section 162 trade or business eligible for the QBI deduction.
Contact us for help to determine if you meet the safe harbor requirements, to implement safe harbor rules, or for a consultation to determine if your rental real estate activity qualifies for the Section 199A QBI deduction irrespective of the safe harbor.