The IRS proposed a safe harbor earlier this year that would give owners or certain real estate interests the opportunity for a qualified business income (QBI) deduction. The Tax Cuts and Jobs Act (TCJA) created the QBI write-off for pass-through entities. The IRS has released final guidance (Revenue Procedure 2019-38) on the safe harbor that clearly describes the requirements taxpayers must satisfy to qualify.
Rundown of QBI
Section 199A was added by the TCJA to the Internal Revenue Code. Overall, it allows partnerships, limited liability companies (LLCs), S-corporations and sole proprietorships to deduct as much as 20% of received QBI. The net amount of income, gains, deductions and losses — excluding reasonable compensation, certain investment items and payments to partners for services rendered — is equal to QBI. The deduction is subject to several significant limitations.
The proposed safe harbor was prompted because many taxpayers in rental real estate activities were uncertain whether they qualified for the deduction. The final guidance leaves no doubt that individuals and entities owning rental real estate, directly or through disregarded entities (entities that aren’t considered separate from their owners for income tax purposes, such as single-member LLCs), may be eligible.
Qualified “rental real estate enterprises” apply to the safe harbor. The term refers to a directly held interest in property held for the rent production, for purposes of the safe harbor only. It may include an interest in a single property or multiple properties.
Each interest in a similar property type can be treated as a separate rental real estate enterprise, or all interests in similar properties can be treated as a single enterprise. Properties that are part of the same rental real estate category are “similar” (that is, residential or commercial). In other words, you can only hold commercial real estate in the same enterprise with other commercial real estate. The same applies for residential properties.
Bear in mind that, if you opt to treat interests in similar properties as a single enterprise, you must do the same in all properties of that category — including newly acquired properties — as long as you use the safe harbor. However, if you choose to treat your interests in each property as a separate enterprise, you can later decide to treat your interests in similar commercial or similar residential properties as a single enterprise.
Notably, the guidance provides that an interest in mixed-use property may be treated as a single rental real estate enterprise or bifurcated into separate residential and commercial interests.
Safe Harbor Requirements
The final guidance clarifies requirements you must fulfill during the tax year in which you wish to claim the safe harbor. Requirements include:
- Keeping separate books and records. When reflecting income and expenses for each rental real estate enterprise, you must maintain separate books and records. If the enterprise includes multiple properties, you can meet this requirement by keeping separate income and expense information statements for each property and consolidating them.
- Performing rental services. At least 250 hours of rental services must be performed each year for enterprises under four years of age. The safe harbor requires this minimum of rental services per year in any three of five consecutive tax years that end with the safe harbor tax year for those at least four years old.
The rental services may be performed by owners, employees, agents or owner contractors. Rental services include:
- Advertising to rent or lease the property
- Negotiating and executing leases
- Verifying tenant application information
- Collecting rent
- Performing daily operation, property maintenance and repair, including materials and supplies purchasing
- 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 do not qualify as rental services.
- Maintaining contemporaneous records. You must keep contemporaneous records for all rental services that describe the service, associated hours, dates and the individuals who performed the service. You can provide services descriptions, the amount of time employees or contractors generally spent performing them, time and wage, or payment records for the individuals if services are performed by employees or contractors. This requirement does not apply to tax years beginning before January 1, 2020. Taxpayers must establish their right to any claimed deductions in all tax years; the IRS cautions filers to be prepared to document QBI deductions.
- Providing a tax return statement. For each year you rely on the safe harbor, you must attach a statement to your original tax return (or on an amended return for the 2018 tax year only). If you have multiple rental real estate enterprises, you can submit a single statement listing the requisite information separately for each.
Real Estate Arrangements That Are Excluded
The safe harbor isn’t available for all rental real estate arrangements. The guidance excludes:
- Real estate used as a taxpayer residence (including a pass-through entity owner or beneficiary)
- 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 is treated as a specified service trade or business (SSTB) for purposes of the QBI deduction; (SSTBs with taxable income above a threshold amount don’t qualify for the deduction)
The guidance states that non-qualifying taxpayers may still be able to establish that an interest in rental real estate is a business for deduction purposes.
The final safe harbor rules apply to tax years ending after December 31, 2017, but you have the option relying on the earlier proposed safe harbor for the 2018 tax year, instead. You must also determine annually whether to use the safe harbor. If you have any questions about the safe harbor rules, contact us and we can help you determine whether you’re eligible for this and other valuable tax breaks.
In order to encourage investment in distressed communities, Congress included in the Tax Cuts and Jobs Act (TCJA) significant tax benefits for…