Real estate investors may qualify for the 20% qualified business deduction enacted as part of the Tax Cuts and Jobs Act (TCJA), subject to certain requirements and conditions as further outlined below. The Internal Revenue Service (IRS) recently published final safe harbor rules for owners of certain rental real estate interests, clarifying the qualified business income (QBI) deduction opportunity. Because the QBI deduction is subject to several significant limitations, this guidance affords needed clarity for many taxpayers involved in rental real estate activities.
The final safe harbor rules apply to qualified “rental real estate enterprises,” which, for purposes of the safe harbor only, refers to an interest in real property directly held for the production of rents. It may consist of an interest in a single property or multiple properties. Each interest in similar property types can be treated as a separate rental real estate enterprise, or all interests in similar property types can be grouped and treated as a single enterprise. Properties are “similar” if they’re part of the same rental real estate category (i.e., residential or commercial). A single enterprise, however, cannot hold both commercial properties and residential properties.
Once interests in similar properties have been treated as a single enterprise, they must continue to be treated as such for interests in all properties of that category—including newly acquired properties—for as long as a taxpayer relies upon the safe harbor. If, on the other hand, a taxpayer has treated interests in multiple similar properties as separate enterprises, the taxpayer can later treat interests in all similar types of properties as a single enterprise.
Notably, the safe harbor guidance states that an interest in mixed-use property may either be treated as a single rental real estate enterprise or bifurcated into separate residential and commercial interests.
Safe Harbor Requirements
To claim the safe harbor, a taxpayer must maintain separate books and records reflecting income and expenses for each rental real estate enterprise. If the enterprise includes multiple properties, this requirement can be met by keeping separate income and expense information statements for each property and combining them.
The safe harbor also requires performing a minimum number of rental service hours. For enterprises in existence less than four years, at least 250 hours of rental services must be performed each year. For those in existence at least four years, at least 250 hours of rental services must be performed per year in any three of the five consecutive tax years that end with the tax year the safe harbor is claimed.
Rental services may be performed by owners or by employees, agents, or contractors of the owners. Rental services include:
- Advertising to rent or lease the property.
- Negotiating and executing leases.
- Verifying tenant application information.
- Collecting rent.
- Performing daily operations, maintenance, and repair of the property, including the purchase of materials and supplies.
- Managing the property.
- Supervising employees and independent contractors.
Financial or investment management activities, studying, or reviewing financial statements or reports, improving property, and traveling to and from the property don’t qualify as rental services.
For all rental services performed, taxpayers must keep contemporaneous records that describe the service; associated hours; dates; and individuals who performed the service, whether performed by owners, employees, or contractors. Although the contemporaneous records requirement will not apply to taxable years beginning prior to January 1, 2020, the IRS cautions that taxpayers bear the burden of showing the right to any claimed deductions, including the QBI deduction, with appropriate documentation.
Taxpayers also must attach a statement to their original tax returns (or, for the 2018 tax year only, an amended return) for each year upon which the safe harbor is relied. Taxpayers with multiple rental real estate enterprises can submit a single statement separately listing the requisite information for each.
Excluded Real Estate Arrangements
The safe harbor isn’t available for all rental real estate arrangements, and excludes:
- Real estate used as a residence by the taxpayer (including an owner or beneficiary of a pass-through entity).
- Real estate rented or leased under a triple-net lease that requires the tenant or lessee to pay taxes, fees, insurance, and maintenance expenses, in addition to rent and utilities.
- Real estate rented to a commonly controlled business.
- The entire rental real estate interest if any part of it is treated as a specified service trade or business (SSTB) for purposes of the QBI deduction.
On an annual basis, taxpayers must decide whether they can or should use the safe harbor. Taxpayers that don’t qualify for the safe harbor may still be able to establish that an ownership interest in rental real estate is a business for purposes of the QBI deduction.
The final safe harbor rules apply to tax years ending after December 31, 2017, and taxpayers have the option of instead relying on the earlier proposed safe harbor rules for the 2018 tax year.
To discuss QBI deductions under the rental real estate safe harbor, or for more information about other real estate tax issues, rules, planning, or advice, contact a PYA executive below at (800) 270-9629.
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