The IRS knows that there has been confusion among taxpayers as to whether or not rental real estate qualifies for the new 20% pass-through deduction on Qualified Business Income (“QBI”). When the IRS sees confusion among taxpayers, they issue revenue procedures (“rev procs”), or documents aiming to provide clarity to and remove ambiguity from the tax code. We just received new proposed rev procs that provide a safe harbor to help taxpayers determine if their rental real estate enterprise qualifies for the 20% QBI Deduction.
Note: A safe harbor is a set of criteria that, if met, ensure that you qualify for a certain outcome without having to go into the nitty-gritty of the law itself. If you don’t meet a safe harbor, you may still qualify, but it will be based on the facts and circumstances of your individual situation and the law in question, and it may be challenged by the IRS.
What do I get if I meet the criteria of the safe harbor?
Meeting the safe harbor means that the real estate enterprise in question will be treated as a trade or business (a technical term in the tax code), therefore allowing it to qualify for the 20% QBI Deduction (which may mean lower taxes for you).
Great, what are the criteria that my rental real estate enterprise has to meet to qualify?
First, you have to know what a rental real estate enterprise (“RREE”) is. An RREE is an interest in real property (or properties) held for the production of rents. This seems obvious when you write it out like that, however, RREEs are subject to certain limitations:
- You (or a pass-through entity you represent) must hold the interest in the RREE directly or through a disregarded entity (like a single-member LLC)
- You must either consider each of your rental properties as separate RREEs or aggregate all similar rental properties into a single RREE for the purpose of this safe harbor. Specifically excluded properties, detailed below, do not need to be included in an RREE. Note, the aggregation mentioned here is different from the aggregation of multiple pass-through entities when calculating the QBI deduction
- A single RREE cannot include both residential and commercial real estate, they must be in separate RREEs
- You must be consistent in your treatment of your properties from year-to-year (unless there is a significant change in facts and circumstances)
Now that you have your RREEs sorted, you need to test each RREE using the following criteria:
- You must maintain separate books and records to reflect the income and expenses for each RREE
- 250 or more hours of rental services must be performed per year with respect to the RREE. Rental services can be performed by owners or by employees, agents, and/or independent contractors of the owner. A detailed list of what counts as a rental service can be found below in Appendix A
- You must maintain contemporaneous records, including time reports, logs, or similar documents that include a description of the service performed, the dates and hours the service was performed, and by whom the service was performed. Note, this requirement does not apply to 2018 (specifically, it does not apply to taxable years beginning prior to January 1, 2019)
You mentioned exclusions – what types of rental activities are excluded from the safe harbor?
The safe harbor specifically excludes the following:
- Real estate used by the taxpayer (including an owner or beneficiary of a pass-through entity) as a residence for any part of the year
- Real estate rented or leased under a triple net lease (i.e. a lease that requires the tenant to pay taxes, fees and insurance, as well as to be responsible for maintenance activities and utilities)
How do I actually claim the safe harbor when I file my tax return?
You (or your pass-through entity) must include a statement that the requirements in Section 3.03 of this revenue procedure have been satisfied. The statement must be signed by the taxpayer and must state “Under penalties of perjury, I (we) declare that I (we) have examined the statement, and, to the best of my (our) knowledge and believe, the statement contains all of the relevant facts relating to the revenue procedure, and such are true, correct, and complete.” In other words, don’t screw around.
This statement must be included on any entity claiming the 20% QBI Deduction, as well as by any entity passing through information pertaining to the 20% QBI Deduction (e.g. on a Form K-1).
I didn’t meet the safe harbor’s requirements. Am I out of luck?
No! While meeting the safe harbor is desirable in that it prevents you from needing to wade through the tax code with regards to your specific facts and circumstances, failing to meet the safe harbor does not preclude you from getting the 20% QBI Deduction for your rental properties if they qualify as a trade or business (for the purposes of this deduction, a.k.a. section 199A). However, making this determination can be tricky and is beyond the scope of this article (if you don’t meet the safe harbor but think you may qualify for the QBI Deduction, our firm can help you make this determination, give us a call).
This rev proc provides some much-needed clarity with regards to rental real estate and the 20% QBI Deduction. It will simplify things for many taxpayers, and while it also excludes some rental property from benefiting from this deduction, it is helpful to remove some of the ambiguity as we ramp up the 2019 tax season.
Didn’t understand something in this article and want more information? Think something here may apply to you or your business? Reach out (or drop a line in the comments below), we can help!
The topics discussed in this article are complex, and we were not able to cover all of the specific details of this aspect of the tax law in only a few pages. You should always consult your tax advisor about your specific situation and circumstances before making any tax planning decisions.
The revenue procedure reviewed in this article is currently “proposed”, and while it may be relied on for 2018 tax returns, the final version of this revenue procedure may differ from the proposed version.
Appendix A – What counts as a rental service?
- Advertising to rent or lease the real estate
- Negotiating and executing leases
- Verifying information contained in prospective tenant applications
- Collection of rent
- Daily operating, maintenance, and repair of the property
- Management of the real estate
- Purchase of materials
- Supervision of employees and independent contractors
The rev proc specifically states that the following financial or investment management activities are not rental services:
- Arranging financing
- Procuring property
- Studying and reviewing financial statements or reports on operations
- Planning, managing, or constructing long-term capital improvements
- Hours spent traveling to and from the real estate