In December 2017, the Tax Cuts and Jobs Act (TCJA) was signed into law. It provided for a new 20% tax deduction on “qualified business income” (QBI). Under Internal Revenue Code (IRC) Section 199A, income from rental real estate businesses qualifies as QBI if the business and related rental income qualifies as trade or business income under IRC Section 162. The Section 199A deduction is scheduled to automatically expire in December 2025. During his presidential campaign, Biden proposed eliminating the 199A deduction for high-income taxpayers, although that elimination has not been included in his most recent budget proposals. To claim the current 199A deduction, it is important for taxpayers who own real estate to demonstrate that they are operating a real estate business as a trade or business and not holding real estate purely for investment. In 2019, the IRS issued Notice 2019-38. This notice provides a safe harbor for landlords to qualify for the IRC Section 199A deduction. There are four requirements that must be met to qualify for the safe harbor:
- Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise. If a rental real estate enterprise contains more than one property, this requirement may be satisfied if income and expense information statements for each property are maintained and then consolidated.
- For rental real estate enterprises that have been in existence less than four years, 250 or more hours of rental services are performed by the taxpayer or other individuals (i.e., plumbers, landscapers, contractors, property managers) per year with respect to the rental enterprise. The activities that count towards the 250-hour requirement include landlord-related duties such as repairs and maintenance, collecting rent, reviewing tenant applications, spending time with tenants, etc. (as described in this revenue procedure) per year with respect to the rental real estate enterprise. For rental real estate enterprises that have been in existence for at least four years, in any three of the five consecutive taxable years that end with the taxable year, 250 or more hours of rental services are performed (as described in this revenue procedure) per year with respect to the rental real estate enterprise; and
- The taxpayer must maintain contemporaneous records of relevant items, including time reports, logs, or similar documents. This requirement applies to tax years beginning after December 31, 2019. Relevant items for recordkeeping include hours of all services performed, description of all services performed, dates on which such services were performed, and who performed the services.
- The taxpayer attaches a statement to a timely filed original return for each taxable year in which the taxpayer relies on the safe harbor. An individual or relevant pass-through entity with more than one rental real estate enterprise relying on this safe harbor may submit a single statement but the statement must list the required information separately for each rental real estate enterprise. The statement must include the following information: (1) A description (including the address and rental category) of all rental real estate properties that are included in each rental real estate enterprise; (2) A description (including the address and rental category) of rental real estate properties acquired and disposed of during the taxable year; and (3) A representation that the requirements of this revenue procedure have been satisfied.
The safe harbor does not apply to triple-net leases. In a typical triple-net lease arrangement, the tenant is responsible for all costs relating to the property being leased. This includes the payment of property taxes, insurance, and repairs and maintenance on the property. Since the tenant is responsible for the costs that would otherwise be the responsibility of the owner, the IRS has taken the position that the rental income from a triple-net lease does not qualify as trade or business income and is merely investment income. In renegotiating lease agreements, owners should make sure the landlord’s responsibilities and services will qualify for the safe harbor, so they are able to claim the 20% deduction on the rental income. Alternatively, another planning opportunity is to evaluate using a Real Estate Investment Trust (REIT) to hold rental property with triple-net leases, since REIT dividends qualify for the deduction.
If a taxpayer does not qualify for the safe harbor as outlined above, business income could still qualify as trade or business income. Taxpayers should work closely with their advisors to review their situation and ensure that appropriate documentation is maintained to substantiate the trade or business requirement.
After concluding that the rental activity qualifies for IRC Section 199A, there are some additional hurdles to overcome before the 20% deduction may be claimed. In 2021, for real estate investors earning over $329,800 for married filing jointly, and $164,900 for single filers, the deduction is limited to a percentage of wages paid with respect to the trade or business, or the combination of a percentage of wages paid, plus a percentage of the unadjusted basis of the property. These limitation thresholds are adjusted annually for inflation with the 2022 threshold rising to $340,100 for joint filers and $170,050 for single filers. When an investor owns multiple rental properties, there are additional planning opportunities to maximize the IRC Section 199A deduction under the aggregation rules.
There are several strategies that can help real estate owners maximize their potential qualified business income deduction and navigate the wage-and-property-test constraints.
If you have questions or would like more information, please contact Christy Woods at cwoods@windes.com or by phone at 844.4WINDES (844.494.6337).
