RENO, Nev. — The IRS issued Rev. Proc. 2019-38 on September 24, 2019 (read more here), finalizing a limited safe harbor initially proposed in January (IRS Notice 2019-07 — read more here) for taxpayers who are direct and indirect owners in rental real estate enterprises.
If you qualify for the safe harbor, will be eligible for an additional 20% deduction (subject to possible limitations).
To be eligible for the 20 percent qualified business income deduction (QBID — again, you can read more here) under the safe harbor, the rental real estate enterprise must meet the following requirements:
1. Maintain separate books and records for each rental real estate enterprise.
2. Perform 250 or more hours of “rental services” each year (for enterprises that have been in existence for more than four years, the 250-hour requirement must be satisfied in three of the five years ending with the tax year). The 250 hours of rental services can be performed by owners, employees, agents, or independent contractors. A rental real estate enterprise can include multiple properties of the same general category (commercial or residential). A commercial rental cannot be part of the same enterprise as a residential rental and vice versa.
Rental services include, advertising for rent or lease, negotiating and executing leases, verifying tenant applications, rent collection, daily operation, maintenance, and repair of property, managing the real estate, purchasing materials, supervision of employees and independent contractors,
Rental services do not include financial or investment management services, arranging financing, procuring property, studying or reviewing financial statements or operating reports, planning, managing, or constructing long-term capital improvements, time spent traveling to and from real estate.
Planning Point: Beginning in 2020, real estate enterprises must maintain contemporaneous documentation similar to the way a law firm might track time spent on client matters. You should document the description, dates and hours of services as well as who performed them. If you have a property manager, make sure they are now breaking their time into these categories.
Taxpayers should also note the four categories of rental properties are not eligible for the safe harbor, regardless of whether the previous requirements discussed above are satisfied:
1. Property used as residence for any part of the year, (think vacation home).
2. Property subject to a triple net lease (i.e., a rental where the tenant is required to pay the taxes, insurance, utilities, and maintenance associated with the property).
3. Property rented to a business with common ownership (i.e., a self-rental).
4. Property where a part is treated as a specified service business under a nuanced rule.
The following example illustrates the application of the safe harbor:
Example: Abby owns two commercial buildings that she rents to third parties on a full-service basis (i.e., the leases are not triple net leases). Abby prepares financial statements for each property.
Each year, Abby and third-party vendors spend 150 hours of rental services per property (300 hours total). Abby keeps contemporaneous time records to prove the amount of time spent on the rentals and treats the two commercial rentals as a single rental enterprise.
The rental enterprise is eligible for the safe harbor and will be treated as a business for purposes of Sec. 199A if Abby makes the safe harbor election.
Variation: If one of the buildings were leased to an S corporation manufacturing business wholly owned by Abby, the rental is a self-rental and is thus ineligible to be part of the rental real estate enterprise.
The self-rental is automatically deemed to be a business for purposes of Sec. 199A under a special self-rental rule. The remaining rental would only involve 150 hours of rental services and thus would not satisfy the 250-hour requirement for the safe harbor.
The rental might otherwise qualify as a business, however, depending on the facts.
If you don't qualify for the safe harbor because, for example, it involves a triple net lease, consider changing your lease terms, etc., to qualify.
After all, a 20% deduction, is a terrible thing to waste!
Planning Point: Many tax software programs must be over-ridden to have self-rentals qualify for the IRC §199A deduction. Add lines 3, 5 & 6 from Form 1040 Schedule 1 and multiply the total by 20%.
Compare that result with Form 1040 line 10 to make sure you are getting full benefit of your deduction. If you are losing benefit, you can plan NOW for 2020. I refer to not losing as #winning!
Please note that this discussion is general in nature, and not intended to be tax advice.
Please consult with a CPA to get answers to your specific fact pattern.
Special note of thanks to CLA's own Ben Darwin & John Werlhof for their assistance on this article.
Michael Bosma, CPA, is Principal-in-Charge of the Reno office of CliftonLarsonAllen LLP. His column, “Covering Your Assets,” focuses on effective planning strategies for every business owner. Reach him for comment at mike.bosma@claconnect.com.
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