The IRS released final guidance this fall to help taxpayers figure out when rental real estate activities might qualify as a “trade or business” for purposes of the Section 199A 20% qualified business income (QBI) deduction.
The final guidance sets forth four requirements that, when met, provide a taxpayer with some assurance that the IRS will recognize the rental real estate activity as a business. In brief, these requirements are:
- Maintain separate books and records to reflect income and expenses for each rental real estate enterprise.
- Perform 250 or more hours of rental services (such as maintenance, operations, lease negotiations, and collections) in at least three of the past five years. Enterprises that are less than four years old must meet this threshold for each year.
- Maintain contemporaneous records of services performed.
- Attach a statement signed by the taxpayer indicating that the safe harbor requirements have been satisfied.
Keep in mind, rental real estate enterprises that don’t meet the safe harbor requirements may still qualify as a trade or business for purposes of the QBI deduction if they otherwise meet the definition of a trade or business in Section 199A. Taxpayers should weigh the benefits of the safe harbor against any changes they might need to make in order to comply.
The 250-Hour Quandary
To understand how a safe harbor requirement might run counter to an existing tax and business strategy, consider the requirement that a taxpayer perform 250 or more hours of rental services during the year for each rental real estate enterprise that he or she wishes to treat as a business. In order to reach this threshold, the IRS allows taxpayers to group all residential properties held for rent into one enterprise and all commercial properties held for rent into a second enterprise.
If you have multiple rental properties, you may have treated each one as an individual enterprise up to this point for a variety of sound reasons. Before you decide to combine multiple properties into one or two consolidated enterprises, you need to weigh the potential benefit of meeting the safe harbor’s 250-hour rule against all the other benefits that individual treatment provides on your tax return and elsewhere.
Triple Net Lease and Personal Residence Restrictions
In addition to the four requirements that each enterprise must meet, there are certain fairly common real estate practices that automatically disqualify a real estate enterprise from coverage under the safe harbor.
Landlords who rely on triple net leases for commercial properties do so for a variety of reasons. Property rented under a triple net lease can’t be included in a rental real estate enterprise under the safe harbor, nor can property that is used by the taxpayer as a residence under section 280A(d). The use of these instruments may disqualify a property from consideration as a rental real estate enterprise for purposes of the safe harbor, but other factors could still qualify the enterprise as a trade or business for purposes of Section 199A. As noted above, a taxpayer in this situation would need to weigh the cost of changing the business model to move away from triple net leases against the likelihood and value of qualifying for the safe harbor.
Consult a Tax Advisor on Risks and Benefits
Just like any tax planning option, the rental real estate safe harbor for the 20% QBI deduction should be evaluated at length with your tax advisor in light of your individual facts and circumstances. There are benefits to establishing bright-line compliance with certain rules that clearly qualify you for a deduction like this. But any discussion of those benefits needs to include a clear understanding of what you may sacrifice in order to qualify for them, and whether or not your activities may qualify for the deduction even if they don’t meet the safe harbor requirements.
To learn more about how your rental real estate activities might qualify for the 20% QBI deduction, please contact your CRI tax advisor.