The Tax Cuts and Jobs Act (TCJA) went into effect in 2018. One good thing about this change in tax law was that QBI offered up to a 20% deduction from qualifying income, so that taxes could be substantially lower for qualifying business activity. In many cases military landlords can qualify for this deduction.
For the landlord’s real estate activity to qualify for QBI the activity must qualify to be treated as a trade or business under Section 199A. Real estate activity can qualify in one of two ways. The activity can meet the definition of trade or business in § 1.199A-1(b)(14) and Section 162. Or the activity can meet the safe harbor provisions in IRS Revenue Procedure 2019-38.
Trade or Business
Most of us would like very specific guidance from the IRS before taking a big deduction and 20% deduction is a big deduction in my book. Unfortunately the part of Section 199A I indicated above essentially sends you to another section stating that if you are operating like a trade or business like the things in that section – then you are a trade or business. Not going to give you a warm fuzzy if you are approaching an IRS audit. However, these are the things the IRS typically looks for in determining whether or not you are operating like a trade or business (the info below is gathered mostly from various IRS sources).
A trade or business is generally an activity carried on for a livelihood or to make a profit. The facts and circumstances of each case determine whether an activity is a trade or business. Some of the important facts and circumstances used to make this determination include:
- regularity of the activities,
- regularity of the transactions,
- production of income, and
- ongoing efforts to further the interests of your business.
- You do not need to make a profit to be operating a trade or business but you do need to have a profit motive.
- You should be able to show that you are doing things to become profitable if you are not.
- You need to keep records or “books”.
- Separating personal accounts from business accounts is helpful in showing the business activity.
- Operating in a business-like manner. Allowing someone to live (particularly a relative) in your “rental” at below market rent may be a red flag that you aren’t really trying to make a profit and operate as a business.
- Do you expect future profit from appreciation of assets?
The IRS has provided a little guidance specific to determining whether a rental real estate activity is a section 162 trade or business. Relevant factors might include, but are not limited to (i) the type of rented property (commercial real property versus residential property), (ii) the number of properties rented, (iii) the owner’s or the owner’s agents day-to-day involvement, (iv) the types and significance of any ancillary services provided under the lease, and (v) the terms of the lease (for example, a net lease versus a traditional lease and a short-term lease versus a long-term lease).
If you don’t want to rely on having to prove you are operating in a business-like manner for claiming QBI if audited – then consider meeting the safe harbor requirements.
The Safe Harbor
A safe harbor from a tax perspective typically means that if you meet the conditions of the safe harbor, the IRS will assume you are handling a tax provision correctly if you meet the conditions required by the safe harbor. This provides you greater assurance of passing an audit and that you are being compliant with the tax code. The safe harbor provision described in IRS RP 2019-38 permits a rental real estate enterprise to be treated as a trade or business for the purposes of this safe harbor if the safe harbor provision is used. A rental real estate enterprise can be one property or it can be a group of properties. You decide if you want to view all your properties as separate rental real estate enterprises or if you want to combine all similar properties into one enterprise -for the purpose of this safe harbor. Note that commercial and residential rental properties cannot be in the same rental real estate enterprise.
The requirements for each rental real estate enterprise (RREE) to meet the safe harbor are:
- 250 or more hours of rental service are performed for each RREE.
- Separate books and records are maintained for each RREE
- Taxpayer maintains contemporaneous records on documenting hours of rental service, services performed, dates of service, and who performed the services.
- A statement must be added to the return for which the safe harbor provision is relied on.
For some landlords 250 hours may seem to be a lot. However, the hours can be done by the owner or contracted out. The hours may also be performed by employees or agents.The biggest obstacle in many cases to meeting the 250 hours is getting a report from those you hired on how many hours they spend on your rental enterprise and in some cases what services were performed. Not all services count for the safe harbor.
The following are considered rental service hours for the safe harbor:
- Advertising for rent or lease
- Lease negotiation and execution
- Verifying information in applications
- Collecting rent
- Daily operations, maintenance, and repairs. This includes the purchase of materials and supplies.
- Management of the real estate
- Supervision of employees and contractors.
Some activities that are expressly NOT rental service hours:
- Financial or investment management activities
- Procuring Properties
- Studying and reviewing financial statements or reports of operations
- Hours spent traveling to and from the real estate properties
- Improving property under § 1.263(a)-3(d). This includes time spent with property improvements that must or can be capitalized and depreciated.
Please note that the information provided in this article does not include all the considerations for qualifying for QBI deductions. For example, you can’t take QBI for a rental property in the year in which there is use of the property as a personal residence and there can be limitations on QBI based on income in some cases. When doing further research on QBI, this page on irs.gov is a good place to start, as well as the 1040 instructions and Pub 535.
This article is not intended to provide specific tax advice for your particular tax situation, but rather to provide some ideas on some of the considerations that may apply for you and to encourage further research and/or consultation with a tax professional.
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