Owners of Rental Properties May Now Qualify for a Pass-Through Business Tax Deduction by Dustin Grizzle
Businesses that own rental property and are organized as pass-through entities recently received welcome guidance from the IRS concerning their ability to qualify for a potential deduction of 20 percent of qualified business income (QBI) that the new tax law introduced at the end of 2017.
Based on the original language contained in the Tax Cuts and Jobs Act (TCJA), it was unclear if owners of rental real estate could qualify for the QBI deduction. For one, it appeared that the income these taxpayers earn from rental activities could be construed as investment income rather than rising to Section 199A’s requirement that it be trade or business income for purposes of claiming the deduction. Moreover, there was uncertainty as to whether real estate brokerage services would qualify as a specialized service trade or business (SSTB) that is either not entitled to the QBI deduction or subject to additional deduction limitations. Over the past year, the IRS has issued a stream of guidance attempting to clarify these and other issues and most recently providing a safe harbor for rental real estate enterprises structured as relevant pass-through entities (RPEs) to qualify for the deduction.
Section 199A Safe Harbor for Real Estate Rentals
The IRS defines a rental real estate enterprise as an interest in real property held for the production of rents that may consist of an interest in multiple properties. To be treated as a trade or business for purposes of claiming the QBI deduction, a real estate enterprise must first be a relevant pass-through entity (RPE) structured as an S corporation, limited liability corporation (LLC), partnership or sole proprietorship, or it must be a trust or estate. It must treat each property it owns for the production of rents as either a separate enterprise, or it must aggregate qualifying businesses together treat all similar properties held for the production of rents as a single enterprise. In both cases, commercial and residential real estate may not be part of the same enterprise, and taxpayers may not vary treatment from year-to-year unless there has been a significant change in their facts and circumstances.
To make a safe harbor election for treatment as a business or trade, taxpayers must also satisfy the following conditions:
- Maintain separate books and records to reflect income and expenses for each rental real estate enterprise;
- Perform at least 250 hours of rental services per year per rental enterprise for tax years 2018 through 2022. Beginning in 2023, taxpayers can satisfy this 250-hour test during three of the five consecutive tax years that end with the tax year;
- Maintain contemporaneous records, including time reports, logs or similar documents that detail the dates, hours and descriptions of all qualifying services performed and by whom for tax years beginning in 2019; and
- Attach to tax returns claiming Section 199A QBI deductions a statement signed by the taxpayer or the RPE’s authorized representative that the entity has satisfied the safe harbor requirements.
It is important for taxpayers to recognize that under the guidance issued by the IRS rental services that qualify as a trade or business may not include financial or investment management activities, such as arranging financing; procuring property; studying and reviewing financial statements or reports on operations; or planning, managing, or constructing long-term capital improvements. In addition, the guidance specifically excludes from the safe harbor test all real estate that taxpayers use as a residence for any portion of the year (such as a vacation home) as well as triple-net-lease (NNN) property, for which tenants are responsible for paying along with their rents property taxes, insurance, utilities and maintenance costs. This last point may require further clarification from the IRS since it could be argued that NNN still constitutes a valid trade or business under the definition contained in Section 162 of the tax code. In addition, the guidance does not change a rule under the TCJA that excludes all items treated as capital gain or loss from the calculation of QBI.
On a final note, taxpayers should understand the rules they must now follow to make an appropriate election to aggregate two or more separate trades or business together in an effort to maximize the QBI deduction, which include the following:
- The same person or persons must own a majority interest in each the business, either directly or indirectly;
- None of the businesses may be considered an SSTB, as defined by the law
- All of the businesses must have the same tax year
- The aggregated businesses must meet two of the following three requirements:
- They provide products and services that are the same or customarily provided together;
- They share facilities or centralized elements; and/or
- They are operated in coordination with, or in reliance on, other businesses in the aggregated group.
The Section 199A QBI deduction can provide significant tax relief to pass-through entities, including those that own rental real estate. However, taxpayers should be aware that calculating the actual tax savings can be quite complex, based on the definition of QBI and the various limitations that can apply to the deduction. For this reason alone, it is critical that businesses work closely with professional tax advisors and accountants to accurately interpret the law and apply it to their unique facts and circumstances.
About the Author: Dustin Grizzle is an associate director of Tax Services with Berkowitz Pollack Brant, where he provides tax-planning and compliance services to high-net-worth individuals and businesses in the manufacturing, real estate management and property investment industries. He can be reached at the CPA firm’s Boca Raton, Fla., office at (561) 361-2000 or via email at firstname.lastname@example.org.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.