By Melinda Kloster
For years beginning after December 31, 2017, a new potential deduction was created that allows eligible taxpayers to deduct up to 20 percent of their qualified business income as a qualified business income (QBI) deduction. For certain high income taxpayers your deduction could be further limited based on your business’ wages and unadjusted basis in qualified property.
Early on, there was a lot of speculation amongst tax professionals as to whether or not a rental property would qualify as a business in order to be able to take advantage of this new QBI deduction. It seemed that with the inclusion of unadjusted basis of qualified property in determining the QBI deduction, that Congress intended for at least some real estate businesses to qualify for the deduction since it allowed taxpayers who rely on revenue-producing assets to benefit. These types of taxpayers are typically in the real estate business.
Then the question became what facts and circumstances would qualify a real estate activity to rise to the level of a trade or business so that its owners could receive the benefit of the QBI deduction.
To answer the many questions and comments they were receiving, the IRS came out with a revenue procedure that provides a safe harbor under which a rental real estate business for eligible taxpayers will automatically be treated as a trade or business. The revenure procedure was finalized in September 2019 and applies only for purposes of QBI deduction.
In order to qualify under this safe harbor, all of the following requirements must be met by the taxpayer:
- Separate books and records must be maintained for each rental real estate enterprise.
- In general, 250 or more hours of rental services were performed in at least three of the past five years. Rental services include advertising to rent or lease the real estate, negotiating and executing leases, verifying tenant applications, collection of rent, daily operation, maintenance and repair of the property, managing the real estate, and supervision of employees and independent contractors. Rental services do not include time spent for financial or investment management services, arranging financing, finding property to purchase, reviewing financial statements or operating reports, travel time to and from the real estate property or time spent related to the construction of long-term capital improvements.
- The taxpayer must maintain contemporaneous records, including time reports, logs, or similar documents regarding hours of all services performed; description of all services performed and dates on which such services were performed; and who performed the services. These services do not have to be performed by the taxpayer. They could be performed by a management company or other employees or contractors.
Certain rental real estate activities are specifically excluded from being able to qualify for the deduction under this safe harbor:
- Real estate used by the taxpayer as a residence
- Real estate rented under a triple net lease
- Real estate rented to a commonly controlled trade or business (self-rental)
- Real estate treated as a specified service trade or business
For example, Hayden and Ella each own a 50% interest in a partnership that owns and operates two apartment buildings. Hayden determines that he performs 25 hours per year of rental services, and Ella determines that she performs 30 hours per year of rental services for each property. In addition, they determine that the property management company performs another 100 hours of rental services on each property. Therefore, each property has 155 hours of rental services. Their bookkeeper maintains a separate set of books for each property, and Ella maintains records of the hours each of them spent on each property. Based on these facts, this rental enterprise would be treated as a business for purposes of the QBI deduction under the safe harbor rules because the total hours performed were 310, which exceeds the 250-hour safe harbor requirement.
Keep in mind, these safe harbors are provided such that if your real estate enterprise meets these safe harbor rules, it will be treated as a single trade or business for purposes of the QBI deduction calculation. However, it is also important to note that if it does not meet all of these safe harbor rules, it does not preclude you from otherwise establishing that an interest in the rental real estate enterprise is a trade or business for purposes of the QBI deduction. Other facts and circumstances may still allow your rental real estate enterprise to rise to the level of a trade or business for the QBI purposes
As usual, there are exceptions to each rule listed above, as well as many different sets of facts and circumstances that could qualify your rental property for the QBI deduction. If you need help determining if your rental enterprise qualifies for the QBI deduction and/ or how to structure the activity such that it would qualify, please contact us so that you do not miss out on this potential deduction.