Rental Activities Qualify for New Tax Break

Written by Nick Sarinelli, CPA, Partner of Nisivoccia LLP
This article appeared in OnSite, the Metropolitan Builders & Contractors Association of New Jersey Magazine. 

 

You may have heard about the new 20% tax deduction for qualified business income (QBI) for so-called “pass-through” entities which are considered a trade or business. However, there has been some uncertainty determining whether owners of rental real estate were eligible for the deduction. Recent IRS guidance addresses this uncertainty with a proposed safe harbor that allows certain real estate enterprises to qualify as a trade or business for purposes of the deduction.

Prior to the recent guidance, owners were left to determine whether their rental real estate qualified as a trade or business.  A trade or business is an activity carried on regularly and continuously for the purpose of making a profit. Sporadic or hobby activities don’t qualify. So, landlords who spend substantial amounts of time managing rental properties would most likely qualify for the deduction. The IRS and courts generally use a facts and circumstances test to determine if a rental real estate activity is a trade or business (as opposed to an investment). Various factors are considered, including the following:

  • The maintenance and repairs supplied by the landlord (or an agent of the landlord);
  • The landlord’s employment of labor to manage the property or provide services to tenants;
  • The landlord’s efforts to rent the property; and
  • The purchase of materials, the payment of expenses, and the collection of rent.

These factors must show that the rental activities are regular and continuous enough to constitute a trade or business. The IRS and courts also consider the type of lease signed by the parties. One arrangement that is of particular concern is the triple net lease. This is where the tenant pays rent, as well as real estate taxes, building insurance, and maintenance costs. In this scenario, it might be difficult to argue that the property owner is regularly and continuously involved in a trade or business.  Another area of concern is where the property is used part of the year for personal use (i.e.: vacation home). 

There is a special rule, however, for self-rentals. The rental of property to a commonly controlled trade or business is treated as a trade or business for purposes of the QBI deduction. For this rule to apply, the same person or group of persons must own 50% or more of the rental activity and the related trade or business.

In addition to qualifying for the deduction based on the factors above, the IRS issued guidance detailing a proposed safe harbor that would allow certain real estate enterprises to claim the deduction.

Generally, the safe harbor provides that eligible rental businesses can claim the deduction if:

  1. Separate books and records are kept to reflect income and expenses for each rental real estate enterprise,
  2. For taxable years through 2022, at least 250 hours of rental services are performed each year for the enterprise. The hours-of-services requirement may be satisfied by work performed by owners, employees or contractors. Qualifying work includes maintenance, repairs, rent collection, expense payment, negotiating and executing leases, and efforts to rent out property. Investment-related activities — for example, arranging financing, procuring property and reviewing financial statements — don’t qualify.  For taxable years after 2022, the 250 hours of rental services may be performed in any three of the five consecutive taxable years that end with the taxable year. And,
  3. The taxpayer maintains contemporaneous records showing the income and expenses, the hours of all services performed, the services performed, the dates they were performed and who performed them.

Be aware that utilizing the safe harbor requires the taxpayer to include a statement attached to the return that the requirements in items A)–C) above had been satisfied. The statement would have to be signed by the taxpayer and include the following language: “Under penalties of perjury, I declare that I have examined the statement, and, to the best of my knowledge and belief, the statement contains all the relevant facts relating to the revenue procedure, and such facts are true, correct, and complete.”   The individual or individuals who signed would have to have personal knowledge of the facts and circumstances related to the statement.

 

Please contact Nick Sarinelli, CPA on 973.298.8500 if you have questions or to discuss this topic further.

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