If you are a real-estate investor, you may be wondering how the new tax law affects you. As part of the Tax Cuts and Jobs Act, individuals, estates, and trusts may deduct 20% of their qualified business income from sole proprietorships and pass-through entities. The new deduction is intended to help equalize the non-corporate tax rates with the new lower corporate tax rate of 21%. When the new law was passed, there were many questions about the definition of a qualified business for the 20% deduction, especially for real estate businesses. The IRS recently issued proposed 199A safe harbor guidelines for certain rental real estate businesses to qualify for the 20% deduction.
What Qualifies a Real Estate Business for the Safe Harbor?
For a real estate business to qualify for the deduction using the proposed IRS guidelines, the following is required:
- Maintaining separate books and records for income and expenses for each rental real estate enterprise.
- Performance of 250 or more hours of qualified rental services (by any person associated with rental).
- Maintaining contemporaneous reports or logs for dates of service, description of services performed, and time logs or similar documents, regarding the following:
- Hours of all services performed
- Description of all services performed
- Dates on which such services were performed
- Who performed the services
The records are to be made available for inspection at the request of the IRS and must be contemporaneous. That means that documentation must be prepared by the time the donor’s income tax return for the year is actually filed or the due date, whichever is earlier.
What are Qualified Rental Services?
Under the guidelines, the following rental activities are qualified rental services:
- Advertising to rent or lease the real estate
- Negotiating 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
What are not Qualified Rental Services?
Under the guidelines, the following rental activities are not qualified rental services:
- Financial or investment management activities
- Procuring property
- Studying and reviewing financial statements or reports on operations
- Planning, managing, or constructing long-term capital improvements
- Real estate used for personal residence by the taxpayer
- Triple net lease arrangements
How do I meet the 250-hour test?
In order to meet the 250-hour test, taxpayers must either treat each real estate business as a separate enterprise or treat all similar activities as a single enterprise. Commercial and residential real estate may not be part of the same enterprise. And of course, your enterprise grouping(s) must remain consistent from year-to-year unless there is a significant change in facts and circumstances. The new guidelines are separate from the real estate professional material participation test which requires more than 750 hours of annual activity per year for the rental income to be treated as non-passive. For both tests, case law is clear that ballpark guesses or estimates, created after-the-fact, will be insufficient.
The contemporaneous records requirement applies for 2019 so now is the time to start documenting who is involved with the rental property, what they are doing on the property, and the number of hours involved. When counting everyone’s hours, that would include janitorial, property management, repairs/maintenance, etc.
How DHJJ Can Help
DHJJ CPAs closely follow the new tax laws and understand how to apply it to your situation. If you would like to speak with one of our CPAs, please contact us below or call 630-420-1360.