Rental Property Owners May Qualify for Pass-Through Business Tax Deduction by Edward N. Cooper, CPA
Posted on October 31, 2019
Businesses that own rental property and are organized as pass-through entities, such as S corporations, partnerships or LLCs, may have a unique ability under the Tax Cuts and Jobs Act (TCJA) to potentially obtain a deduction for up to 20 percent of the qualified business income (QBI) they generate from leasing real estate.
Section 199A of the tax reform law provides a deduction to non-corporate taxpayers of up to 20 percent of the qualified business income from each of the taxpayer’s qualified trades or businesses, including those operated through a partnership, S corporation, or sole proprietorship, as well as a deduction of up to 20 percent of aggregate real estate investment trust dividends and qualified publicly traded partnership income.
Based on the original language of the law, however, it was unclear whether a taxpayer’s ownership interest in rental real estate rises to the level of a trade or business for purposes of claiming the QBI deduction, or if the income generated by those interests should be considered investment income subject to ordinary income tax at personal rates as high as 37 percent.
On September 24, 2019, more than 21 months after the TCJA was signed into law, the IRS issued Revenue Procedure 2019-38 further clarifying and making permanent the availability of a safe harbor for certain rental real estate enterprises structured as relevant pass-through entities (RPEs) to qualify as a trade or business for purposes of the QBI deduction.
Section 199A Safe Harbor for Real Estate Rentals
Solely for the use of this safe harbor, the IRS defines a qualifying rental real estate enterprise as an interest in either a single property or multiple properties held to generate rental or lease income.
The taxpayer or RPE relying on this revenue procedure must hold each interest directly or through an entity disregarded as an entity separate from its owner, such as a limited liability company with a single member. Moreover, taxpayers must treat each property it owns for the production of rent as either a separate enterprise, or it must aggregate qualifying businesses together and treat all similar properties held for the production of rent as one single enterprise. However, for purposes of aggregation, commercial and residential real estate may not be part of the same enterprise. Taxpayers may not vary their treatment from year-to-year, unless there has been a significant change in their facts and circumstances.
If a taxpayer treats interests in similar commercial properties or similar residential properties as a single rental real estate enterprise, the taxpayer must continue to treat interests in all similar properties, including newly acquired properties, in the same manner in order to qualify for the safe harbor. However, if taxpayers choose to treat interests in each residential or commercial property as separate rental real estate enterprises, they may elect in the future to treat those interests in all similar commercial or all similar residential properties as a single rental real estate enterprise.
With regard to mixed-use property that has residential and commercial units, the final regulation clarify that taxpayers may treat their interests as either a single rental real estate enterprise or they may bifurcate the property into separate residential and commercial interests. However, an interest in mixed-use property that a taxpayer treats as a single rental real estate enterprise, may not be treated as part of the same enterprise as other residential, commercial, or mixed-use property.
To make a safe harbor election for treatment as a business or trade, taxpayers must satisfy the following conditions:
- Rental real estate enterprises in existence for less than four years must perform a minimum of 250 or more hours of rental services per year; whereas rental real estate enterprises in existence for four years or more must perform 250 or more hours of rental services in at least three of the past five years.
- Maintain separate books and records to reflect income and expenses for each rental real estate enterprise;
- 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; and
- Attach a statement to each annual tax return indicating that the taxpayer or RPE is relying on the safe harbor provisions.
It is critical that taxpayers recognize the final regulations specifically exclude from the safe harbor test all real estate taxpayers use as personal residences as well as triple-net-lease (NNN) property for which tenants are responsible for paying property taxes, insurance, utilities and maintenance costs along with their rental payments. In addition, none of the businesses may be considered specialized service trades or businesses, as defined by the law.
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: Edward N. Cooper, CPA, is director-in-charge of Tax Services with Berkowitz Pollack Brant, where he provides business- and tax-consulting services to real estate entities, multi-national companies, investment funds and high-net-worth individuals. He can be reached at the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or via email at email@example.com.
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.