The Tax Cuts & Jobs Act offered businesses the most significant tax cuts in a generation. C corporations saw their maximum Federal tax rate cut almost in half from 39% to 21%. Partnerships, S corporations and sole proprietorships also received significant tax relief in the form of a 20% tax deduction for Qualified Business Income. When the law passed, many of us had one question – does the IRS consider rental real estate a business that qualifies for the QBI deduction?
We have received some guidance, but more is needed. The IRS provided a “safe harbor” whereby owners of rental real estate can qualify for a tax deduction of up to 20% of their net profit from rental real estate activities. The article is meant to give an overview of the pathway to this deduction.
For the purpose of claiming the QBI deduction, a rental real estate enterprise will be treated as a trade or business if the following requirements are satisfied during the taxable year:
- Separate financial books and records are maintained to reflect income and expenses for each rental real estate enterprise.
- 250 hours of rental services required. For taxable years beginning prior to 1/1/2023, 250 or more hours of rental services are performed per year with respect to the rental real estate enterprise. For taxable years beginning after 12/31/2022, the 250 hour requirement needs to be met in any three of five consecutive taxable years that end with the filing year.
- Document rental services performed. The landlord must maintain contemporaneous records, including time reports, logs or similar information documenting the hours of all services performed, the dates the services were provided and a description of the type of service and who performed the service. These services include advertising or renting the property; negotiating a lease agreement; verifying tenant information; rent collection; repairs and maintenance of the property; purchase of supplies; and supervision of employees, agents, and employees.
- Consider other workers on the property. The 250 hour requirement can be met by the landlord or by the landlord’s employees, agents or independent contractors. This would seem to indicate that the work of a painter that is painting the property would count toward the 250 hour requirement. The only issue would be how to determine the number of hours the painter worked on the job, the gardener spent mowing the lawn or the plumber spent fixing the leaky faucet.
- Election statement required. An annual election statement must be included with the landlord’s tax return to claim the QBI deduction under the safe harbor described above.
Activities such as driving to and from the property, or investor-type activities such as arranging financing, or reviewing financial data do not count toward the 250 hour safe harbor. Real estate rented under a triple net lease is not eligible for the safe harbor, nor is property that is used partly as a residence whose deductions are limited under Section 280A. For example, a condo in Mammoth that is used 180 days by the owner and rented out for 100 days would not qualify for the deduction.
What if you can’t meet the 250 hour requirement for your rental property? There are other ways that landlords can qualify for the QBI deduction. For example, a taxpayer can elect to aggregate two or more properties for the purpose of meeting the 250 hour test. In order to aggregate properties, the landlord must own 50% or more of each property for the majority of the tax year, and must own all aggregated properties on the last day of the tax year. The properties must be similar in nature such that they would be customarily offered together. For example, residential and commercial real estate could not be included in the same group. Also, there must be centralized business elements that oversee or provide services to the aggregated properties.
It is also possible for a business owner who uses a separate entity (e.g. an LLC) to lease real property to their business to aggregate the business and the rental property for the purpose of meeting the 250 hour requirement and claiming the QBI deduction.
Lastly, a rental real estate enterprise may qualify for the QBI deduction based on “facts and circumstances.” That means, in the IRS’ view, that all facts would lead a reasonable person to conclude that the property or properties are clearly a business worthy of the deduction.
Once an individual chooses to aggregate two or more trades or businesses, the individual must consistently report the aggregated properties in all subsequent tax years. Aggregation does not always benefit a taxpayer, so it is important to “run the numbers” to determine whether it is right for you. Also, the QBI deduction can be limited based income or other factors.
This is a summary of the safe harbor and aggregation rules for rental real estate. They are obviously complex, so we advise clients to take a careful look at them before proceeding.
Does it sound complicated? It is, and we probably need a more guidance from the IRS to determine where to draw the lines. So tread carefully, but be aware of this wonderful tax planning opportunity for landlords.
Call us, or see your tax advisor for more information.