Rental Real Estate and the Qualified Business Income Tax Deduction
The Tax Cuts and Job Act established the qualified business income (QBI) tax deduction in section 199A of the Internal Revenue Code. Congress enacted section 199A to provide a deduction to non-corporate taxpayers of up to 20 percent of the taxpayer’s qualified business income from a qualified trade or business, including businesses operated as partnerships, LLCs taxed as partnerships, S corporations, and sole proprietorships. Income from employee services and investment activities does not qualify.
With regard to rental activity, a question often arises about whether the activity is merely an investment or whether it is a genuine trade or business, and the QBI deduction makes it more important than ever to correctly analyze this issue. Part of the difficulty is that the Internal Revenue Code does not define the term “trade or business,” and while the term has been defined by case law, the definition does not always fit well with rental activities. Although section 199A defines a “qualified trade or business” by excluding certain specified services (e.g., accounting, legal, health, and financial services, among others), as well as services an individual provides as an employee, it provides no guidance for rental real estate activities.
To help clarify the uncertainty surrounding this issue, the IRS recently published a revenue procedure that creates a safe harbor for treating certain rental real estate activities as a trade or business solely for purposes of section 199A. The safe harbor is available to taxpayers who claim the QBI deduction under section 199A with respect to a “rental real estate enterprise.” 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 a single property or interests in multiple properties.” The taxpayer claiming the QBI deduction must hold this interest directly or through an entity that is disregarded for tax purposes. The determination of whether the safe harbor can be utilized is made on an annual basis. In order to rely on the safe harbor, the taxpayer must satisfy all of the requirements described in the revenue procedure. However, even if a rental activity does not meet all of the requirements of the safe harbor, it may nevertheless be considered a qualified trade or business since this determination is ultimately based on all of the relevant facts and circumstances.
The safe harbor requirements for a rental real estate enterprise to be treated as a trade or business are as follows:
- Books and Records. Separate books and records must be maintained to reflect income and expenses for each rental real estate enterprise. If a rental real estate enterprise contains more than one property, the books and records requirement may be satisfied if income and expense information statements for each property are maintained separately and then consolidated.
- 250 Hours. The general requirement is that 250 or more hours of “rental services” (defined below) must be performed per year for the rental real estate enterprise. If a rental real estate enterprise has been in existence for at least four years, the 250-hour requirement must be satisfied in any three of the previous five consecutive taxable years.
- Contemporaneous Records. The taxpayer must maintain contemporaneous records, including time reports, logs, or similar documents, regarding the following:
(a) Hours of all services performed;
(b) Description of all services performed;
(c) Dates on which such services were performed; and
(d) Who performed the services.
- Annual Statement. The taxpayer must attach a statement to a timely filed original return (or an amended return for the 2018 taxable year only) for each taxable year in which the taxpayer relies on the safe harbor. The statement must include the following information:
(a) A description (including the address and rental category) of all rental real estate properties that are included in each rental real estate enterprise;
(b) A description (including the address and rental category) of rental real estate properties acquired and disposed of during the taxable year; and
(c) A statement that the requirements of the revenue procedure have been satisfied.
For purposes of satisfying the 250-hour requirement for rental services, the IRS has provided examples of the types of services that qualify for the safe harbor. They include but are not limited to the following:
- Advertising to rent or lease the real estate;
- Negotiating and executing leases;
- Verifying information contained in prospective tenant applications;
- Collecting rent;
- Daily operation, maintenance, and repair of the property, including the purchase of materials and supplies;
- Management of the real estate; and
- Supervising employees and independent contractors.
Rental services may be performed by owners, including by owners of a pass-through entity that owns the real estate, or by employees, agents, or independent contractors of the owners. Significantly, the term “rental services” does not include financial or investment management activities, such as arranging financing; procuring property; studying and reviewing financial statements or reports on operations; capital improvements; or hours spent traveling to and from the real estate.
It also important to note, and many landlords will be disappointed to learn, that several types of property are excluded from a rental real estate enterprise and are therefore not eligible for the safe harbor. These include the following:
- Real estate used by the taxpayer (including an owner or beneficiary of a pass-through entity that owns the real estate) as a personal residence;
- Real estate rented or leased under a triple net lease (which is defined in the IRS revenue procedure to mean a lease agreement that requires the tenant to pay taxes, fees, and insurance, and to pay for maintenance activities for a property in addition to rent and utilities);
- Real estate rented to a trade or business conducted by a taxpayer or a pass-through entity that is commonly controlled (based on 50 percent or more common ownership including direct or indirect ownership through related parties); and
- The entire rental real estate interest if any portion of the interest is treated as a specified service trade or business (based on 50 percent or more common ownership including direct or indirect ownership through related parties).
The key point of the safe harbor and the 199A regulations that deal with rental real estate is to distinguish actively managed rental activities from those that are more in the nature of an investment. Unfortunately, the 199A regulations do not create a bright line test that can be used by a rental activity to determine if it qualifies as a trade or business. Although the safe harbor does provide some guidance in this regard, it may nevertheless have limited application as a result of the many exclusions noted above, particularly the exclusion regarding property subject to a triple net lease. But an owner whose rental activity would otherwise qualify for the safe harbor but for the fact that a triple net lease is utilized may wish to consider modifying the lease to shift some of the responsibilities back to the owner. And if it becomes apparent that it is simply not possible to qualify for the QBI deduction, never fear: section 199A is scheduled to be repealed in 2026 unless Congress acts to make it permanent.
DISCLAIMER: The foregoing does not constitute legal advice and has been prepared for informational purposes only. Please contact us directly with questions about how these and other laws and procedures relate to your specific situation.
Prepared by GKH attorney Doug Smith. Attorney Smith practices in the areas of Estate Planning and Administration, Business Succession Planning, Nonprofit Organization, Corporate and Commercial Law, and Tax Law.