Major update regarding the new Tax Law
IRS Releases Final Regulations Under Section 199A (20% Deduction)
It’s been over a year since the Tax Cuts and Jobs Act has been passed, and the IRS is providing the final pieces of clarity of the infamous section 199A deduction which allows you to not pay tax on 20% of the Qualified Business Income. In previous articles and publications we have taken each individual proposed regulation or finalized regulation and defined it in order to give you, the reader, the best possible understanding of how to apply the complicated deduction. So to continue the trend, today we have one more section 199A piece to discuss, this time involving rental real estate enterprises.
The IRS in Notice 2019-7 provided that a rental real estate enterprise will be treated as a trade or business solely for purposes of section 199A. Some people might ask, what is a rental real estate enterprise and how do I qualify? In short, a rental real estate enterprise is a primary form of income based on rental properties. The courts have often found there is a simple test whether a taxpayer’s activity qualifies to meet the level that constitutes a trade or business, the test being: (1) regular and continuous conduct of the activity, which depends on the extent of the taxpayer’s activities; and (2) a primary purpose to earn profit, which depends on the taxpayer’s state of mind and good faith intention to make a profit from the activity. By meeting these requirements with your rental property, you should be in line for the 20% qualified business deduction.
Additionally, it will be imperative that the taxpayer meet the IRS’s definition of rental real estate enterprise in order to qualify for the safe harbor. Per the IRS, the definition is, “an interest in real property held for the production of rents and may consist of an interest in multiple properties.” For consistency sake, the IRS has decided that taxpayers must either treat each individual rental property as a separate enterprise, or in the alternative treat all of them as a single enterprise. However, commercial and residential real estate may not be part of the same enterprise. Finally, taxpayers may not pick and choose enterprise variations year by year unless there is a drastic change in facts surrounding the properties.
Furthermore, for the sole purpose of section 199A, a rental real estate enterprise will qualify for the 20% qualified business deduction if the following requirements are met (within that taxable year):
- Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise;
- For taxable years beginning prior to January 1, 2023, 250 or more hours of rental services are performed (as described in the revenue procedure) per year with respect to the rental enterprise. For taxable years beginning after December 31, 2022, in any three of the five consecutive taxable years that end with the taxable year (or in each year for an enterprise held for less than five years), 250 or more hours of rental services are performed (as described in the revenue procedure) per year with respect to the rental real estate enterprise; and
- The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, regarding the following: (i) hours of all services performed; (ii) description of all services performed; (iii) dates on which such services were performed; and (iv) who performed the services. Such records are to be made available for inspection at the request of the IRS. The contemporaneous records requirement will not apply to taxable years beginning prior to January 1, 2019.
Moreover, if you have questions about what qualifies as a rental service the list below is a list of services the IRS has deemed as rental services:
- Advertising to rent or lease the real estate
- Negotiation 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
There are some exclusions that owners should be aware of. First and foremost, real estate used by the taxpayer (including owner or beneficiary) as a residence is not eligible for the 199A deduction. Another exclusion is any real estate rented or leased under a triple net lease. The IRS states a triple net lease includes a lease agreement requiring the tenant or lessee to be responsible for the taxes, fees, insurance, and maintenance activities, in addition to rent and utilities, on the property.
All in all, the 199A deduction was a key part of the Tax Cuts and Jobs Act, which continues to be fleshed out. Now that the final regulations are coming to fruition, we can look toward the future of using the deductions soundly. If you have further questions about the 199A deduction or other tax questions, contact us at the Center for Financial, Legal & Tax Planning, Inc., at (618) 997-3436.