20% Rental Real Estate Deduction – Is 250 Hour Safe Harbor Necessary?
In 2018, the Tax Cuts and Jobs Act (TCJA) introduced the 199A Qualified Business Income (QBI) Deduction, promising a 20% deduction from taxable income derived from qualified trades or businesses. That meant a taxpayer earning $10,000 in qualifying income would only pay taxes on $8,000 of said income. The initial guidance from the IRS made it clear that in order to qualify for the 20% QBI deduction, income must first be sourced through either a U.S. partnership, S-Corporation, or sole proprietorship (C-Corporations have been explicitly disallowed this deduction due to their tax rate dropping to a flat 21% in 2018). However, at the time, it was unclear as to whether participation in real estate rental activities would be considered a trade or business as defined by Section 199A. This left many taxpayers wondering if their rental activity would qualify for the deduction at all.
Due to the confusion, the IRS released Notice 2019-7, which offered a definition of a “real estate enterprise” and an annually determined safe harbor available to taxpayers seeking to claim the 199A deduction with respect to a rental real estate enterprise. According to the IRS, a real estate enterprise for purposes of the QBI deduction is an interest in real property held for the production of rents, which may consist of an interest in one property or multiple properties, as long as commercial and residential properties are not grouped together within the same enterprise (enterprises but be completely composed of either commercial rentals or residential rentals). Under this safe harbor, a rental real estate enterprise will be deemed a trade or business and therefore, eligible for the 20% deduction on net rental income derived from their qualifying rental real estate enterprise (subject to limitations upon reaching certain taxable income levels). In order to satisfy the requirements for the safe harbor election, the rental real estate enterprise must complete the following:
- Maintain separate books and records to reflect income and expenses for each rental real estate enterprise
- Maintain records regarding hours/dates/descriptions of services performed
- Perform 250 or more hours per year of rental services with respect to the enterprise
- Attach a signed statement, under penalties of perjury, to a timely filed original return for each taxable year in which the taxpayer relies on the safe harbor that all requirements have been satisfied
Item number 3 was discouraging to taxpayers, as many viewed that number as unmanageable to reach in a given year. However, these safe harbor requirements should be of no concern, as Section 1 of Notice 2019-7 reads:
If an enterprise fails to satisfy (the safe harbor) requirements, the rental real estate enterprise may still be treated as a trade or business for purposes of Section 199A if the enterprise otherwise meets the definition of trade or business (under section 162).
Meaning, as long as a taxpayer’s rental activity meets the definition of a trade or business, their income shall qualify for the 20% QBI deduction, regardless of whether the 250-hour condition is met. In order for the IRS to view a rental activity as a trade or business, we recommend the following:
- Involvement with the property should be continuous, either personally or through an agent such as a property manager
- Maintain separate books, records, and bank accounts for rental activities
- Issue all required 1099’s
Essentially, if a taxpayer wants the IRS to view their rental activities as a business, they should treat them as such. The safe harbor may be elected by taxpayers who meet its requirements, but it should not be seen as the only way a rental activity can be considered a trade or business by the IRS and take advantage of the QBI deduction.
Please note that the IRS has been clear that triple net leases do not qualify for the QBI deduction, regardless of the taxpayer meeting the safe harbor requirements or conducting their activities as a trade or business. Also, be aware that income derived from self-rentals to the following “Specified Service Trades or Businesses” (as they are referred to under section 199A) may qualify for the 20% deduction, but the deduction phases out and is eventually lost at certain income thresholds ($326,600-$426,600 in 2020 for married taxpayers who file jointly):
- medical services
- actuarial science
- performing arts
- financial services
- brokerage services (not real estate brokers)
The rules of the Qualified Business Income Deduction can be difficult to navigate. If you have any questions, please contact us for further assistance.
By Aaron Lavarias, CPA
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