The IRS recently issued guidance on the new deduction for up to 20% of qualified business income (QBI) from pass-through entities under the Tax Cuts and Jobs Act (TCJA). It aims to clarify when the QBI deduction is available for income from rental real estate enterprises.
The QBI deduction is allowed only for income from a business. But the term "business" isn't defined in the statutory language. When the TCJA became law, it was unclear whether a rental real estate activity could count as a business for QBI deduction purposes. Here's how the new guidance helps clarify the issue.
The QBI deduction is potentially available to eligible noncorporate owners of pass-through business entities for tax years beginning in 2018 and extending through 2025. The deduction is scheduled to disappear after 2025, unless Congress extends it.
For QBI deduction purposes, pass-through entities are defined as:
The QBI deduction is complex and involves a number of rules. For example, the deduction:
Income from the trade or business of being an employee doesn't count as QBI. Also excluded from QBI are reasonable salaries collected by S corporation shareholder-employees and guaranteed payments received by partners (or LLC members treated as partners for tax purposes) for services rendered to partnerships (or LLCs) or for the use of capital by partnerships (or LLCs).
Important: The QBI deduction can also be claimed for up to 20% of an individual's income from qualified real estate investment trust (REIT) dividends and up to 20% of qualified income from publicly traded partnerships (PTPs).
Above specified income levels, the QBI deduction for income from an eligible business can't exceed the greater of:
In addition, the QBI deduction is phased out for income from specified service businesses. Examples include doctors, lawyers, accountants, actuaries, actors, singers, consultants, athletes, investment managers, stock traders and any other trade or business where the principal asset is the reputation or skill of one or more of its employees.
For 2018, these limitations are phased in when the business owner has taxable income (calculated before any QBI deduction) above certain levels. These income limits are indexed annually for inflation. Here are the income-based phase-in thresholds for 2018 and 2019:
These limitations are phased in over a taxable income range of $50,000, or $100,000 for married couples who file joint returns.
Under another limitation, an individual's allowable QBI deduction can't exceed the lesser of:
The IRS recently issued Notice 2019-7 to clarify when the QBI deduction can be claimed for income from rental real estate enterprises. The notice includes a safe-harbor rule for determining whether a rental real estate enterprise can be treated as an eligible business for QBI deduction purposes.
If a rental real estate enterprise fails to qualify for the safe-harbor rule, it can still be treated as a business for QBI deduction purposes if it meets the general definition of a business set forth in the QBI regulations. Unfortunately, that definition isn't very clear. (See "Defining a Business under the QBI Regulations" above.)
For purposes of eligibility for the safe-harbor rule, a rental real estate enterprise is defined as an ownership interest in real property held for the production of rents and may consist of an ownership interest in multiple properties.
To rely on the safe-harbor rule, the individual or pass-through entity must own the interest directly or through an entity that's disregarded for federal income tax purposes. Such entities include single-member LLCs that aren't treated for tax purposes as separate entities apart from their owners.
Taxpayers must either treat:
Commercial and residential real estate can't be treated as part of the same enterprise. Taxpayers also aren't allowed to vary their treatment of properties from year to year, unless there's a significant change in facts and circumstances.
To be eligible for the safe harbor, the taxpayer must pass an hours-of-service test. For tax years beginning before January 1, 2023, at least 250 hours of rental services must be performed each year in the enterprise.
For tax years beginning after December 31, 2022, the 250-hour test can be met in any three of the five consecutive tax years that end with the current tax year. But if the enterprise has been held for less than five years, the 250-hour test must be met for each post-2022 tax year.
For tax years beginning after December 31, 2018, eligible taxpayers must maintain separate books and records for each rental real estate enterprise to keep track of each enterprise's income and expenses. Taxpayers must also maintain contemporaneous records (including time reports, logs, or similar documents) to establish:
For purposes of meeting the hours-of-service test, rental services include:
Rental services can be performed by owners, employees, agents and independent contractors. Rental services do not include financial or investment management activities, such as:
Real estate used as a residence by the taxpayer (including an owner or beneficiary of a pass-through entity) for any part of a tax year isn't eligible for the safe-harbor rule. Real estate rented or leased under a triple net lease also isn't eligible. With a triple net lease, the tenant or lessee, in addition to paying rent and utilities, agrees to pay taxes, fees and insurance, and to be responsible for property maintenance.
For a rental real estate enterprise that's been in existence for fewer than four years, at least 250 hours of rental services must be performed each year for income from the enterprise to count as QBI.
For a rental real estate enterprise that's been in existence for at least four years, at least 250 hours of rental services must be performed during each of any of three of the five consecutive tax years that end with the current tax year.
For purposes of passing the hours-of-service tests, rental services include:
Rental services can be performed by owners (including owners of an RPE), employees, agents and independent contractors.
Important: Rental services do not include financial or investment management activities. Examples of non-qualifying activities include:
To prove that the hours-of-service test was passed, taxpayers must maintain contemporaneous records including time reports, logs or similar documents to establish:
If services are performed by employees or independent contractors, you can provide:
Such records must be supplied to the IRS upon request.
Important: The contemporaneous record keeping requirements for the hours-of-service tests do not apply to tax years beginning before January 1, 2020. So, calendar-year 2018 and 2019 federal income tax returns aren't affected. However, in the event of an audit, taxpayers bear the burden of proving that they're entitled to any claimed deductions. So you still need to maintain records.
The individual, estate, trust or RPE that owns a rental real estate enterprise must attach a statement to a timely filed original federal income tax return (or an amended return for the 2018 tax year) for each tax year in which the taxpayer relies on the safe harbor. The statement must include the following information:
An individual, estate, trust or RPE that owns more than one rental real estate enterprise can submit a single statement. But the statement must list the required information separately for each rental real estate enterprise.
The following types of property can't be classified as a part of a rental real estate enterprise and are, therefore, ineligible for the QBI deduction safe harbor rule:
A triple net lease is a lease agreement that requires the tenant or lessee of the property to pay taxes, fees, insurance and for maintenance of the property in addition to paying the rent and utilities.
There's a special rule that applies to self-rentals. The rental or licensing of tangible or intangible property that doesn't rise to the level of a Section 162 trade or business is still treated as a trade or business for QBI deduction eligibility purposes if the property is rented or licensed to a business conducted by an individual or RPE that has 50% or more common ownership (considering indirect ownership). See "Defining the Term 'Trade or Business'" below for a plain English description of what property qualifies for the QBI safe harbor.
For this rule to apply, the same person or group of persons must own (directly or indirectly under attribution rules) the business to which the property is rented. For example, if Sue rents real property that she owns under a triple net lease arrangement to her wholly owned S corporation for use in the S corporation's business, the net rental income would count as QBI.
The Notice 2019-7 guidance on the eligibility of rental real estate enterprises for the QBI deduction isn't final. But it can be relied upon until final rules are issued by the IRS. Meanwhile, taxpayers should be aware that complying with the recordkeeping requirements in Notice 2019-7 may be a challenge. Your tax advisor can help you set up procedures to meet the challenge.
Here's the plain English adaption of the definition of the term "trade or business" for QBI deduction eligibility purposes, according to IRS regulations. A trade or business means an activity that's a trade or business under Section 162 of the Internal Revenue Code, other than the trade or business of being an employee. (Sec. 162 is the part of the tax law that allows deductions for business-related expenses.)
Unfortunately, this definition requires parsing old-and-cold case law to determine when a rental activity constitutes a Sec. 162 trade or business. That said, a rental activity will generally be a Sec. 162 trade or business under case law, unless the property owner just collects the rent without doing much else (such as the lessor for a triple net lease).
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