By Scott Wolkens
The IRS recently issued guidance on the new deduction for up to 20% of qualified business income (QBI) under the Tax Cuts and Jobs Act (TCJA). If you own rental real estate, this article contains important information you need to consider for your rental properties starting this year!
If all the general requirements (which vary based on your level of taxable income) are met, the deduction can be claimed for a rental real estate activity--but only if the activity rises to the level of being a trade or business. An activity is generally considered to be a trade or business if that activity is regular, continuous, and considerable. To illustrate, if the property owner merely collects the rent without really doing much else, the rental is more passive in nature and thus won't qualify for the QBI deduction.
Because determining whether a rental real estate enterprise meets those criteria can be difficult, the IRS has provided a safe harbor under which such an enterprise will be treated as a trade or business for purposes of the QBI deduction if certain conditions are met. For this purpose, a rental real estate enterprise is defined as an interest in real property held for the production of rents and may consist of an interest in multiple properties. Commercial and residential real estate may not be part of the same enterprise.
Under the safe harbor, a rental real estate enterprise will be treated as a trade or business if the following requirements are satisfied during the tax year with respect to the rental real estate enterprise:
(1) Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise.
(2) 250 or more hours of rental services are performed per year with respect to the rental enterprise. Note that these hours of service do not have to be performed by you personally. This means that services can also be performed by employees, agents and independent contractors or businesses you hire. So, for example, if you have hired a service contractor to perform service at your rental property, that service would count toward the total hours (provided they meet rule #3 below).
(3) The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, regarding the following: (i) hours of all services performed; (ii) description of all services performed; (iii) dates on which such services were performed; and (iv) who performed the services. Such records are to be made available for inspection at the request of the IRS. The contemporaneous records requirement is effective beginning the 2019 tax year.
For purposes of meeting the hours-of-service test, rental services include:
Rental services do NOT include financial or investment management activities, such as:
Ineligible Property Types
Some types of rental real estate are not eligible for the safe harbor. Real estate used as a residence by the taxpayer (including an owner or beneficiary of a pass-through entity) for any part of a tax year isn’t eligible for the safe-harbor rule. Real estate rented or leased under a triple net lease also isn’t eligible. With a triple net lease, the tenant or lessee, in addition to paying rent and utilities, agrees to pay taxes, fees and insurance, and to be responsible for property maintenance.
Taking the Deduction on your 2018 Tax Return
When we prepare your return and notice that you have either income or expenses for rental real estate, we'll contact you to consult with you and provide you the qualification requirements (which are listed above). If you advise us that your rental real estate meets the eligibility requirements, we'll claim the deduction and safe harbor for you on your tax return. The IRS also requires that all taxpayers include a statement attached to their tax return that claims that the requirements in Section 3.03 (above) have been satisfied. To make it easy for you, we'll provide you a form with the required statement that you must sign. And we'll include it in your return for you. As always, our goal is to make it easy for you!
QBI Loss & Anti-Abuse Rules
The rental real estate QBI deduction is only computed on net profit of your rental(s). If you have a net loss on your rental property, there's no deduction to take. However, if your property qualifies for the QBI deduction safe harbor rules, the amount of your loss is tracked for QBI purposes for subsequent tax returns. For example, if you had a net $5,000 loss on your rental property in 2018, and then had a net profit of $12,000 on your rental property in 2019, your QBI deduction on your 2019 return will be 20% of $7,000 ($12,000 minus $5,000). For this reason, to avoid abuse, taxpayers also aren’t allowed to vary their treatment of properties from year to year, unless there’s a significant change in facts and circumstances.
Taking the Deduction in Future Tax Years
IRS Notice 2019-7 guidance on the eligibility of rental real estate enterprises for the QBI deduction isn’t final. But it can be relied upon until final rules are issued by the IRS. Meanwhile, if you qualify for QBI under the minimum hours provision, you should be aware that you need to start complying with the recordkeeping requirements as of January 1, 2019. No specific format is required. So Excel, Word or a journal log will suffice, as long as all the pertinent details are recorded.