On January 18, 2019, the Internal Revenue Service finalized regulations for the new tax deduction on qualified business income (QBI) from pass-thru entities. IRC section 199A now contains a safe harbor provision listing the requirements for rental activities to be recognized as a qualified trade or business, which is a prerequisite for eligibility to receive the 20% QBI deduction.
Overview of the Pass-Thru Tax Deduction
As explained in my previous post, the new tax benefit created under the Tax Cuts and Jobs Act (TCJA) potentially provides taxpayers with a deduction of 20% of qualified business income from a qualified trade or business that is operated as a sole proprietorship, partnership, S-corporation, estate or trust. Pursuant to IRC section 199A, the QBI deduction is limited to income from a qualified trade or business, which the IRS defines as every trade or business other than:
- the trade or business of performing services as an employee, and
- any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, etc.
Uncertainty surrounding sec. 199A & rental activites
One of the initial uncertainties of the new law was the lack of definitive guidance for determining whether a particular rental activity qualified as a trade or business. The significance of this issue cannot be overstated, because only income from a qualified trade or business is potentially eligible for the 20% deduction under section 199A.
In response to concerns raised by tax practitioners and real estate professionals, the government added a safe harbor provision to the final regs. to assist taxpayers and their advisers with determining if their real estate activities qualify as a trade or business.
Before explaining the section 199A safe harbor provision, please be aware of the IRS definition for a rental real estate enterprise.
The safe harbor provides clarity, sort of…
For purposes of IRC section 199A, a rental real estate enterprise is treated as a qualifying trade or business if it meets the following requirements:
- Separate books and records are maintained for each rental real estate enterprise,
- At least 250 hours of rental services are performed per year (for taxable years beginning after December 31, 2022, in any 3 of the 5 consecutive taxable years), and
- Taxpayer maintains contemporaneous records (time reports, logs, etc.) specifying (a) hours of all services performed, (b) description of services performed, (c) dates on which such services were performed, and (d) the person(s) who performed the services.
It is important to note that the 250 rental service hours may be performed by owners, employees, agents or contractors. The following rental services may be used in satisfying this requirement:
- Advertising to rent or lease the real estate,
- Negotiating and executing leases,
- Verifying information in lease applications,
- Collecting rent,
- Daily operation, maintenance and repair of the property,
- Managing the property,
- Purchasing materials, and
- Supervising employees and independent contractors.
However, IRC section 199A expressly prohibits financial or investment management activities such as arranging financing, procuring property, constructing capital improvements, and transportation between properties.
Another quirky feature of this law are the restrictions it appears to place directly on commercial rent property. For example, real estate leased under a triple net lease (common to commercial space used in retail) is not eligible for the safe harbor.
Lastly, a rental real estate enterprise that fails to be treated as a qualified trade or business under the safe harbor provision of section 199A can still achieve the benchmark based on the facts and circumstances of its rental activities. That said, the “facts and circumstances determination” involves heavy reliance on subjective criteria and one’s own judgment (topics the Revenue Service could easily challenge in the event of an examination). A
–IRC Section 199A – IRS Provides Trade or Business Safe Harbor for Rental Real Estate by J. Matsumura & Bob McGrath
–New regulations provide rental real estate safe harbor for 20% pass-through deduction by Paul Dillon and Mike Schiavo