When the Tax Cuts and Jobs Act of 2017 (tax reform) was passed, it opened the door to a bevy of new tax-saving opportunities for businesses. Not only was the overall corporate tax rate reduced, but several new tax-saving incentives were introduced/extended including bonus depreciation and the qualified business income deduction (Section 199a). The deduction permits certain taxpayers the opportunity to deduct up to 20% of their qualifying business income on their tax return. While it was initially clear how the deduction would work for certain businesses, there was confusion for others. Specifically, rental real estate companies were unsure how, and if, the deduction could be applied to their business. Unfortunately, the law did not specify whether rental real estate activity would be considered a trade or business that would qualify for the deduction. For clarification, the IRS issued proposed regulations to demystify the issue and give some guidance and has now issued final guidance. To help clients, prospects and others understand the guidance, Hanson & Co has provided a summary of key points below.
Proposed Regulations – Quick Review
The purpose of the proposed regulations was to provide qualifying safe harbor criteria for real estate companies involved in the rental business. If these criteria are met, then the business could be considered a qualifying trade or business for purposes of the deduction.
- Separate Books – The proposed regulations mandated that separate books be kept and maintained for each rental real estate enterprise.
- 250 Hour Test – For rental real estate enterprises with a taxable year through 2022, it’s required that 250 or more hours of rental services are performed annually. For taxable years starting in 2023, the requirement is slightly different requiring 250 or more hours yearly of rental services performed in at least three of the last five consecutive tax years.
- “Services” Recordkeeping – Taxpayers are required to maintain specific records, including time reports, logs, and other documentation, that highlight the hours of all services performed, description of those services, dates when performed and information on who performed the documented services. It’s important to note these records need to be made available to the IRS for inspection if requested for taxable years starting in 2019.
What are Rental Services?
For purposes of the qualification, rental services are defined as rental advertising, validation of information on tenant applications, collection of rent, daily operations including maintenance and property repairs, real estate management, acquisition of materials and, finally, supervision of employees and independent contractors.
Final Regulations – What Changed?
The final regulations (Revenue Procedure 2019-38) confirmed much of what was already outlined in the proposed regulations but also included additional information and more helpful information.
- Separate Books – Separate books be kept and maintained for each rental real estate enterprise. If the rental enterprise contains more than one property, income and expense should be maintained on an individual basis and then consolidated.
- 250 Hour Test – For rental real estate enterprises that have been in business for three years or less, it’s required that 250 or more hours of rental services are performed annually. For rental enterprises that have been in business for four years or more, the requirement is slightly different requiring 250 or more hours yearly of rental services performed in at least three of the last five consecutive tax years.
- “Services” Recordkeeping – Taxpayers are required to maintain specific records, including time reports, logs, and other documentation, that highlight the hours of all services performed, description of those services, dates when performed and information on who performed the documented services. If services were provided by an employee or independent contractor, records must reflect the time it took such person along with wage and payment records. It’s important to note these records need to be made available to the IRS for inspection if requested for taxable years starting in 2020.
- Filing Documentation -The taxpayer should attach a statement to their tax return that states they are relying on the safe harbor. The information for each rental enterprise considered under the safe harbor should include all the addresses if aggregated, rental category, acquired and disposed of properties included in the aggregation if applicable, and representation that safe harbor requirements have been met for all properties or aggregations.
- Prohibited Properties – There was additional guidance given on the type of properties that are excluded from being considered as part of a rental real estate enterprise. These include properties being used as a residence by the taxpayer, properties rented under a triple net lease, those rented to one of the taxpayer’s other businesses and properties treated as specified service trades or business under Section 199a.
- Effective Date – Almost all parts of Revenue Procedure 2019-38 are effective no later than the 2019 tax year but can be applied retroactively to taxable years ending in 2018.
- Aggregation Rules – Taxpayers can aggregate interests in similar properties and treat them as a single rental real estate enterprise to help them pass the safe harbor requirements, but only when:
- The properties are in a similar category (residential or commercial)
- Newly acquired properties in the same category are added to the existing enterprise if previously aggregated.
The recent guidance issued by the IRS for rental real estate enterprises will make it easier for companies to determine if they qualify under the safe harbor rules. Since the rules and regulations are complicated, it’s important to consult with a qualified advisor to determine how you are impacted. If you have questions or need assistance with a real estate tax planning or audit issue, Hanson & Co can help! For additional information please call us at 303-388-1010 or click here to contact us. We look forward to speaking with you soon.