The Tax Cuts and Jobs Act (TCJA) introduced a new deduction for individuals, estates and trusts that own interests in so-called “pass-through” business entities for 2018 through 2025. The deduction can equal up to 20% of an owner’s share of qualified business income (QBI) from an interest in one or more pass-through business entities. The QBI deduction is subject to limitations for higher-income owners, but it can be an important tax-saving break for many small business owners.
The eligibility rules for this deduction have been a source of confusion. Only income from a “business” counts as QBI — but the term “business” isn’t defined in the statutory language that created the QBI deduction. So, there was a question about whether a rental real estate venture could be classified as a business for QBI deduction eligibility purposes.
Defining the Term “Trade or Business”
Here’s the plain English adaption of the definition of the term “trade or business” for QBI deduction eligibility purposes, according to IRS regulations. A trade or business means an activity that’s a trade or business under Section 162 of the Internal Revenue Code, other than the trade or business of being an employee. (Sec. 162 is the part of the tax law that allows deductions for business-related expenses.)
Unfortunately, this definition requires parsing old-and-cold case law to determine when a rental activity constitutes a Sec. 162 trade or business. That said, a rental activity will generally be a Sec. 162 trade or business under case law, unless the property owner just collects the rent without doing much else (such as the lessor for a triple net lease). However, there’s an important exception for self-rental properties. (See main article.)
Important: Pass-through businesses include sole proprietorships, disregarded single-member limited liability companies (SMLLCs) that are treated as sole proprietorships for tax purposes, partnerships, LLCs that are treated as partnership for tax purposes and S corporations.
Official Safe Harbor Rule
The IRS published Notice 2019-7 in January 2019. It set forth a temporary safe harbor rule that would allow income from an eligible rental real estate enterprise to be classified as QBI.
Then, in September 2019, the IRS issued Revenue Procedure 2019-38. It made the safe harbor rule official and finalized the eligibility requirements. Here’s how to take advantage of the safe harbor rule.
Definition of Rental Real Estate Enterprise and Ownership Test
For purposes of eligibility for the safe harbor rule, a rental real estate enterprise is defined as an ownership interest in real property held for the production of rents and may consist of ownership interests in multiple properties. Property can be owned directly by an individual, estate or trust. Or it can be owned indirectly by an individual, estate or trust through a relevant pass-through entity (RPE). An RPE is a partnership, LLC treated as a partnership for tax purposes or an S corporation.
Each ownership interest can be treated as a separate rental real estate enterprise — or all interests in similar properties can be combined and treated as a single rental real estate enterprise.
Interests in residential rental property are considered similar. Likewise, interests in commercial rental property are considered similar. In other words, an interest in commercial rental real estate can be combined only with one or more other interests in commercial rental real estate, and an interest in residential rental real estate can be combined only with one or more other interests in residential rental real estate.
To rely on the safe harbor rule, the individual, estate, trust or RPE must own the interest directly or through an entity that’s disregarded for federal income tax purposes. Such disregarded entities include disregarded SMLLCs that aren’t treated for tax purposes as separate entities apart from their owners.
Treatment of Properties
Taxpayers must either:
1. Treat each property held for the production of rents as a separate rental real estate enterprise, or
2. Treat all similar properties held for the production of rents as a single rental real estate enterprise.
Commercial and residential real estate can’t be treated as part of the same enterprise. Taxpayers also can’t vary their treatment of properties from year-to-year unless there’s a significant change in facts and circumstances.
Important: Taxpayers must maintain separate books and records to reflect income and expenses for each rental real estate enterprise. If a rental real estate enterprise consists of more than one property, this requirement can be satisfied if income and expense information is maintained for each property and then consolidated.
For a rental real estate enterprise that’s been in existence for fewer than four years, at least 250 hours of rental services must be performed each year for income from the enterprise to count as QBI.
For a rental real estate enterprise that’s been in existence for at least four years, at least 250 hours of rental services must be performed during each of any of three of the five consecutive tax years that end with the current tax year.
For purposes of passing the hours-of-service tests, rental services include:
•Advertising to rent or lease real estate,
•Negotiating and executing leases,
•Verifying information contained in prospective tenant applications,
•Performing daily operation, maintenance and repair of property,
•Purchasing materials, and
•Supervising employees and independent contractors.
Rental services can be performed by owners (including owners of an RPE), employees, agents and independent contractors.
Important: Rental services do not include financial or investment management activities. Examples of non-qualifying activities include:
•Studying and reviewing financial statements or reports of operations,
•Planning, managing or constructing long-term capital improvements, and
•Traveling to and from properties.
Record Keeping Requirements
To prove that the hours-of-service test was passed, taxpayers must maintain contemporaneous records including time reports, logs or similar documents to establish:
•Hours for all services performed,
•Descriptions of all services performed,
•Dates on which the services were performed, and
•Who performed the services.
If services are performed by employees or independent contractors, you can provide:
•A description of the services performed by each employee or independent contractor,
•The amount of time the employee or independent contractor generally spends performing such services, and
•Time, wage or payment records for the employee or independent contractor.
Such records must be supplied to the IRS upon request.
Important: The contemporaneous record keeping requirements for the hours-of-service tests do not apply to tax years beginning before January 1, 2020. So, calendar-year 2018 and 2019 federal income tax returns aren’t affected. However, in the event of an audit, taxpayers bear the burden of proving that they’re entitled to any claimed deductions. So you still need to maintain records.
Tax Return Statement Requirement
The individual, estate, trust or RPE that owns a rental real estate enterprise must attach a statement to a timely filed original federal income tax return (or an amended return for the 2018 tax year) for each tax year in which the taxpayer relies on the safe harbor. The statement must include the following information:
• A description, including the address and rental category, of all rental real estate properties that are included in each rental real estate enterprise,
•A description, including the address and rental category, of rental real estate properties acquired and disposed of during the tax year, and
•A representation that the requirements of Revenue Procedure 2019-38 have been satisfied.
An individual, estate, trust or RPE that owns more than one rental real estate enterprise can submit a single statement. But the statement must list the required information separately for each rental real estate enterprise.
The following types of property can’t be classified as a part of a rental real estate enterprise and are, therefore, ineligible for the QBI deduction safe harbor rule:
•Real estate used by the taxpayer, including an owner or beneficiary of an RPE, as a personal residence,
•Real estate rented or leased under a “triple net” lease, and
•The entire rental real estate interest if any portion of the interest is treated as part of a specified service trade or business under the QBI deduction regulations (such as an affected professional services business).
A triple net lease is a lease agreement that requires the tenant or lessee of the property to pay taxes, fees, insurance and for maintenance of the property in addition to paying the rent and utilities.
There’s a special rule that applies to self-rentals. The rental or licensing of tangible or intangible property that doesn’t rise to the level of a Section 162 trade or business is still treated as a trade or business for QBI deduction eligibility purposes if the property is rented or licensed to a business conducted by an individual or RPE that has 50% or more common ownership (considering indirect ownership). See “Defining the Term ‘Trade or Business'” at right for a plain English description of what property qualifies for the QBI safe harbor.
For this rule to apply, the same person or group of persons must own (directly or indirectly under attribution rules) the business to which the property is rented. For example, if Sue rents real property that she owns under a triple net lease arrangement to her wholly owned S corporation for use in the S corporation’s business, the net rental income would count as QBI.
The safe harbor rule and related definitions and requirements detailed in Revenue Procedure 2019-38 generally apply to tax years ending after December 31, 2017. For more information, contact your tax advisor.