IRS gives rental owners clarity on 20% deduction

Print Friendly

The IRS on Friday gave owners of rental properties a better idea of how they can qualify for the 20 percent deduction on qualified business income from pass-through entities such as sole proprietorships, partnerships and S corporations.

This deduction is a big, complicated part of the sweeping Tax Cuts and Jobs Act that Congress passed in December 2017. It’s called the qualified business income deduction, or the 199A deduction after its section in the tax code.

The IRS published proposed regulations for this deduction in August, but the section on rental real estate left room for debate. It said that to qualify, a real estate activity must rise to the level of a “trade or business,” an ambiguous term that has no clear or consistent definition in the tax code. The IRS said it would look to its use under section 162(a) of the tax code, but that still left a lot of tax pros arguing about whether people who owned one or a few properties would qualify.

The IRS published final regulations on the overall deduction Friday, but clarified its position on rental real estate in a separate notice.

“The Treasury Department and the IRS are aware that whether a rental real estate enterprise is a trade or business is the subject of uncertainty for some taxpayers,” it said in the notice. “To help mitigate this uncertainty,” the notice contains a proposed revenue procedure that provides a “safe harbor” under which a rental real estate enterprise will be treated as a trade or business under Section 199A and thereby qualify for the 20 percent deduction starting with the 2018 tax year.

The notice outlines numerous requirements, but here’s the big one: Between 2018 and 2022, at least 250 hours of rental services must be performed each year for the business. Starting in 2023, at least 250 hours must be performed in three of the five past years.

Rental services under this definition include advertising the space for rent, negotiating and executing leases, screening tenants, collecting rent, maintenance and repairs, purchasing materials and supervising employees and independent contractors. “Rental services may be performed by owners or by employees, agents, and/or independent contractors,” the notice said.

It added that rental services do not include financial or investment management activities, such as arranging financing, procuring property, studying financial statements and hours spent traveling to and from the real estate.

Also, real estate used by the owner “as a residence for any part of the year” is not eligible for this safe harbor.

It also added that real estate rented under a triple net lease is not eligible. A triple net lease is one that requires the tenant to pay taxes, fees, and insurance, and to be responsible for maintenance in addition to rent and utilities.

To benefit from the deduction, “the rentals must show a profit,” said Frank Lloyd, an enrolled agent in Los Altos Hills. “My experience is that the majority of self-rented homes and condos is they show losses. Losses are due to high interest, real estate taxes, and depreciation.”

For small-time real estate investors, “it’s a mixed bag,” said Jeff Levine, CEO of Blueprint Wealth Management. “On the whole it’s good. We have a much better idea what the IRS is looking for. It’s the closest to a bright-line test that we’ve had.”

To qualify for the safe harbor, taxpayers must own the rental property in their own name or in an entity that is taxed as if it’s in their own name, Levine said. If you have to file a separate tax return for the rental business, it would not qualify for the safe harbor.

Real estate owners who fail the safe-harbor test could still make a case that they qualify for the deduction, but this makes it harder to prove, he said.

Source: sfchronicle.com