It can be difficult to determine which expenses meet the standard for qualified business income for rental properties. The Internal Revenue Service recently issued final guidance on a limited safe harbor. This article will help you understand these complex regulations.
When the Tax Cuts and Jobs Act of 2017 added the qualified business income (QBI) deduction (also called the Section 199A deduction), it didn’t clarify when a rental activity rises to the level of a qualified trade or business. On September 24, 2019, the Internal Revenue Service (IRS) finalized a limited safe harbor for taxpayers who are direct and indirect owners in rental real estate enterprises (Rev. Proc. 2019-38).
Subject to certain limitations, taxpayers who qualify for the safe harbor are eligible for the 20% QBI deduction. If your enterprise is profitable, taking this deduction may be a good tax strategy – at least through 2025 when it is set to expire if Congress does not extend it.
The enterprise can include multiple properties in the same general category, either commercial or residential. To be eligible under the safe harbor rules, the rental real estate enterprise must meet the following requirements:
- Perform 250 or more hours of rental services each year. Enterprises that have been in existence for more than four years, must meet this requirement in three of the last five years. Owners, employees, agents or independent contractors can perform these hours.
- Maintain separate books and records for each rental real estate enterprise. These records should document the hours and dates of all services performed, provide a description of all services performed and include a list of who performed the services. (Beginning in 2020, these records will have to be maintained contemporaneously.)
- Submit a signed statement stating that all of the tests have been satisfied for each year this deduction is claimed.
Which services can be included?
For purposes of the safe harbor rule, rental services include the following: daily operations, maintenance, repairs, rent collection, payment of expenses, provision of services to tenants and efforts to rent the property (such as advertising). They do not, however, include financial or investment management services, arranging financing, procuring property, reviewing financial statements or operating reports or time spent traveling to and from the rental property.
The following types of rental properties are specifically excluded from claiming the QBI deduction:
- Property used as residence for any part of the year, such as a vacation home.
- Property subject to a triple net lease.
- Property rented to a business with common ownership.
- Property where a part is treated as a specified service business excluded from claiming the QBI deduction.
How do losses affect the reduction?
Remember that if your rental property generates losses, the QBI deduction may not be the best tax strategy for your enterprise to pursue. Those losses would reduce the 20% deduction. For some rental real estate enterprises with losses, claiming the QBI deduction can cost thousands. It may make more sense to simply deduct your losses against your ordinary income. As with any tax planning strategy, you need to evaluate the pros and cons in your specific situation.