Safe Harbor for Lessors Who Rent Real Estate
Lessors of rental property can significantly save income taxes if their rental activities are considered a trade or business.
There has been much publicity about the safe harbor rule under which a rental real estate enterprise will be treated as a trade or business for purposes of Section (Sec.) 199A of the Internal Revenue Code (IRC).
Why is Sec. 199A important?
As part of the Tax Cut and Jobs Act, Congress enacted Sec. 199A to provide a deduction to non-corporate taxpayers of up to 20 percent of the taxpayer’s qualified business income (QBI) from each of the taxpayer’s qualified trades or businesses, including those operated through pass-thru entities such as partnerships, S corporations, or sole proprietorships. In other words, qualifying taxpayers can receive an additional 20% tax deduction.
Real estate business taxpayers need to review their operations to determine if they meet the requirements to qualify as a trade or business for the QBI deduction under the safe harbor requirements.
Our focus for purposes of this post will be on individual taxpayers and not on relevant passthrough entities, real estate investment trusts, and qualified publicly traded partnership income which may be eligible for the 20% QBI deduction.
What Is A Trade or Business?
There is much uncertainty as to whether an interest in rental real estate is a trade or business for purposes of Sec. 199A. To assist taxpayers, a proposed version of an IRS Revenue Procedure was released that contains a safe harbor for treating a rental real estate enterprise as a trade or business solely for purposes of Sec. 199A (to claim the 20% tax deduction).
In order to rely upon the safe harbor, individual taxpayers must satisfy certain requirements. It should be noted that individuals who do not meet all the safe harbor requirements are not precluded from otherwise establishing that an interest in rental real estate is a trade or business for purpose of Sec. 199A.
Our focus will be on how individuals meet the safe harbor requirements.
What Are the Safe Harbor Requirements?
It is important to note that lessors who wish to use the safe harbor test must meet the requirements annually.
Requirement #1: Separate books and records must be retained to reflect the income and expenses for each rental real estate enterprise. If a rental real estate enterprise contains more than one rental property, this requirement may be satisfied if individual records are maintained for each property and then consolidated.
Requirement #2: If in existence for less than 4 years, 250 or more hours of rental services (defined below) must be performed for the rental real estate enterprise. If in existence for at least 4 years, 250 or more hours of rental services must have been performed in three of the five consecutive tax years that end with the current tax year in which the safe harbor is claimed.
Requirement #3: The taxpayer must maintain contemporaneous records, including time reports, logs, or similar documents that reflect (i) hours of all services performed; (ii) description of the services performed; (iii) dates on which such services were performed; and (iv) who performed the services.
If an employee or independent contractor performs the services for the landlord, the detailed information described above must be maintained for each employee and/or independent contractor and the time, wage, or contractor payment records must be maintained by the lessor and available for IRS inspection.
This 20% QBI deduction was effective for the 2018 tax year. If a taxpayer failed to claim the QBI deduction in a previously filed 2018 tax return, the QBI deduction can be claimed with the filing of an amended tax return.
For each year that the taxpayer relies upon the safe harbor (remember that it is an annual test), the IRS requires that the taxpayer attach a statement to the return. If the taxpayer has more than one rental property relying upon the safe harbor test, a single statement can be submitted, BUT, the statement must list the required information separately for each rental real estate enterprise. Consult with your tax advisor as to the information required to be shown on the statement.
What Are Rental Services?
Rental services include, but are not limited to, advertising to rent or lease real estate; negotiating and executing leases; verifying information in tenant applications; collection of rent; daily operation, maintenance, and repair of the property; purchasing of materials and supplies; management of the property; supervision of employees and independent contractors.
Rental services may be performed by owners, employees, agents and/or independent contractors.
Rental services do NOT include financial or investment management activities, such as arranging financing; procuring properties; studying and reviewing financial statements or reports on operations, improving the property under IRS Reg. 1.263(a)-3(d), or time spent traveling to and from the rental real estate.
What Types of Properties Are Not Eligible for the Safe Harbor?
- Real estate used by the taxpayer.
- Real estate rented or leased under a triple net lease.
- Real estate rented to a trade or business conducted by the taxpayer.
Contemporaneous Records Exception:
Surprisingly, the contemporaneous records requirement will NOT apply to tax years beginning prior to January 1, 2020. However, the requirement that the taxpayer bears the burden of proof showing the right to any claimed deductions (including the 20% QBI deduction) remains in effect as it does for any claimed tax deduction.
What Is Your Next Step?
Not to sound self-serving, but this additional 20% tax deduction is a great tax benefit to lessors. If you self-prepare your own tax returns and are not already working with an experienced tax professional, perhaps it is time to reconsider that decision, especially if you need to amend your 2018 Form 1040 if the 20% QBI was not claimed on the original return and you qualify for it.
If you are going to claim that your rental is a trade or business, it needs to follow the trade and business requirements. For example, you will need to satisfy the Form 1099-MISC filing requirements for independent contractors.
Bryan Haarlander, an Enrolled Agent and a Certified Tax Resolution Specialist, is an affiliate member of the Suburban West Realtors® Association, a member of the American Society of Tax Problem Solvers (ASTPS), PA Society of Tax & Accounting Professionals (PSTAP), the National Society of Accountants (NSA) and the National Association of Tax Professionals (NATP). He is the author of “How to Resolve Your IRS Tax Debt Problems” as well as a book on how to start your own business. He has been practicing in Exton for 18 years. His blogs http://www.taxexpertblog.com and http://www.stopmytaxproblems.com discuss pertinent tax and business issues.
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