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For more than 30 years, CPA professionals have not experienced such a significant change to the Internal Revenue Code until the Tax Cuts and Jobs Act (TCJA) of December 2017. One of the many changes that were established by the TCJA is the new Code Section 199A, which allows certain non-corporate taxpayers to take up to 20% deduction of their qualified business income (QBI). The IRS defines QBI as “for any taxable year, the net amount of qualified items of income, gain, deduction, and loss concerning any trade or business of the taxpayer…” Generally, the 20% deduction is available to owners of pass-through businesses that operate within the United States, as well as individuals and some estates and trust. However, it is limited for specified service trades or businesses (SSTB) and not available for wage income and income earned through a C corporation. The 2018 taxable income for Section 199A deduction is limited to $315,000 for a married couple filing a joint return, or $157,500 for all other taxpayers. The threshold amounts will be adjusted for inflation in subsequent years.
How does Section 199A affect real estate investors? Will rental income qualify for QBI and the 20% deduction?
The IRS released Notice 2019-07 that provides for a safe harbor under which a rental real estate enterprise will be treated as a trade or business and applies to taxpayers with taxable years ending after December 31, 2017. Section 199A(d) defines a qualified trade or business as any trade or business other than a specified service trade or business (SSTB) or a trade or business of performing services as an employee.
Per the IRS Notice 2019-07, the rental activity will be treated as a trade or business if the following safe harbor requirements are met:
First, each rental enterprise should maintain separate books and records to reflect income and expenses. Rental enterprise is an interest in real estate that is held to produce rents. A rental enterprise may consist of one or multiple similar rental properties.
Second, at least 250 or more hours of rental services must be performed per year concerning the rental enterprise. The services can be performed by owners, agents, independent contractors or the employees including time spent on advertising, collection of rent, supervision of employees, operations, maintenance, and repairs. However, the IRS excluded time spent on financial and investment management activities such as arranging financing; studying and reviewing financial statements or reports on operations; procuring property; time spent traveling to and from the real estate; planning, managing, and constructing long-term capital improvements, from 250 hours of rental services.
The last requirement will apply to taxable years beginning after January 1, 2019, and requires the taxpayers to maintain contemporaneous records. The owners of rental enterprises should effectively document information, such as descriptions, dates, time spent and by who the work was done, on all services performed on rental real estate activities. Although taxpayers don’t need to file these records, it should be kept and be available for inspection at the IRS’s request.
As those requirements are met, the rental enterprise is going to be considered as a trade or business solely for purposes of Section 199A and the income qualifies for the pass-through deduction up to 20%.
Unfortunately, the safe harbor can’t be used for properties which taxpayer rents and uses as personal property for more than 14 days per year. In addition, real estate that is rented or leased under a triple net lease do not qualify as well. If you think you don’t qualify for the safe harbor, don’t worry. We can argue facts and circumstance because each taxpayer’s situation differs. Whether the property is commercial or residential, the lease terms, services provided, how many properties owned and day-to-day involvement in the activity all play a role.
There are many strategies that can be used to make Section 199A rules work for each specific taxpayer. Meet with your CPA to discuss and create tax strategies that will fit your situation.
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