Rental Activities & the Qualified Business Income Deduction

Kristi Jeffres, CPA (May, 2019)

There are still many questions that arise as soon as anyone mentions the Qualified Business Income (QBI) Deduction. In our November Focus article, we took a look at various aspects of the deduction. Today, we are going to take a deep dive into Rental Activities and whether or not they qualify as a trade or business for purposes of this new deduction and when rental real estate businesses are eligible to be aggregated.

Rental Property – is it a Qualified Trade or Business?

As a refresher, in order to take the QBI deduction, a taxpayer first must determine whether they own a qualified trade or business. IRC §199A does not specifically define qualified trade or business, but the regulations clarify that a qualified trade or business is any activity that is regularly and continuously carried on with an intent to make a profit. One of the biggest questions that arose with the new §199A deduction was whether rental property would be considered a trade or business. The final regulations began to address this question, but left room for a lot of judgement.  

Currently, there are two safe harbors in place to claim that your rental property is a trade or business. First, is for self-rental type property. If a taxpayer is renting property to another entity with common ownership, the rental income received will be considered qualified trade or business income eligible for the §199A deduction. Secondly, the IRS issued Notice 2019-07 with an additional safe harbor for rental properties, discussed below. If the rental property does not meet either safe harbor, the property will be subject to a facts and circumstances test and be required to follow case law as discussed in our last QBI article. Click here to read.

Safe Harbor for Rentals as Qualified Trades or Businesses (Notice 2019-07)

The first question when relying on this newly issued safe harbor is whether or not you are eligible to follow this safe harbor at all. This safe harbor applies to individual taxpayers and relevant pass through entities (“RPE”) including, partnerships, S-corporations, estates, or trusts that are “rental real estate enterprises.” A rental real estate enterprise is defined as an interest in real property held for production of rents and may consist of an interest in multiple properties. If there are multiple properties within one enterprise, taxpayers must either treat each property held for the production of rents as a separate enterprise or treat all similar properties held for the production of rents as a single enterprise. The exception, is that commercial and residential real estate may not be part of the same enterprise and triple net leases and properties used as a personal residence throughout the year are excluded from this safe harbor altogether. In addition, the individual or RPE using this safe harbor must hold interest directly or through a disregarded entity.

What are the Requirements of the Safe Harbor?

If you meet the definition of a qualified trade or business using the safe harbor rules, what additional requirements need to be met?

1)      Separate books and records must be maintained for each rental real estate enterprise

2)      250 or more hours of rental services are performed during the year for each rental real estate enterprise

3)      Taxpayers must maintain contemporaneous records, including time reports or logs, regarding: hours of services performed, description of services performed, dates on which such services were performs, and who performed the services. These records must be available for inspection at the request of the IRS.

The safe harbor requires 250 hours of rental services to be performed during the year for the rental real estate enterprise, but allows these services to be performed by a variety of different people including owners, employees, agents, and independent contractors of the owners. The rental services that are considered in the 250 hour test include:

  • Advertising to rent or lease the real estate
  • Negotiating and executing leases
  • Verifying information contained in prospective tenant applications
  • Collection of rent
  • Daily operation, maintenance, and repair of the property
  • Management of the real estate
  • Purchase of materials
  • Supervision of employees and independent contractors

Rental services do not include financial or investment management activities, such as arranging financing, procuring property, studying and reviewing financial statements or reports on operations, planning, mandating, or constructing long-term capital improvements or hours spent traveling to and from the real estate.

If a taxpayer is relying on the safe harbor provided in Notice 2019-07 they must attach a signed statement to their return and they may not vary this treatment from year-to-year unless there has been a significant change in facts and circumstances. It is important to note that if a rental real estate enterprise fails to satisfy the requirements of the safe harbor, 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 in the regulations.

Aggregation of Rental Activities

Once a taxpayer has determined that their rental properties are considered qualified trades or businesses, they may consider aggregation. When a taxpayer chooses to aggregate trades or businesses for purposes of the QBI deduction, qualified business income, W-2 wages, and the unadjusted basis of qualifying property from each qualified trade or business is aggregated together as if it were from one trade or business. This is potentially beneficial if a taxpayer has multiple businesses that generate QBI and only one of them pays W-2 wages. Aggregating the businesses as if they were one may increase the deduction the taxpayer is eligible for when phase-outs apply.

The final regulations clarified that taxpayers with rental properties may be eligible to aggregate properties that are of the same type.  Provided that the taxpayer meets all other requirements for aggregation (discussed here), the taxpayer is eligible to aggregate commercial rental properties with other commercial rental properties and residential rental properties with other residential rental properties. Taxpayers cannot aggregate commercial rental properties with residential rental properties.

If you have any questions, or if you would like to speak with one of our tax professionals to analyze your potential section 199A deduction, please contact us at (315) 471-9171.

 

The information reflected in this article was current at the time of publication.  This information will not be modified or updated for any subsequent tax law changes, if any.

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