Are You Eligible for the IRS 199A Rental Property Tax Deduction?
The question of whether rental property is eligible for the new 20% pass-through deduction is a significant question within the new tax law. The recently released final regulations under IRC 199A, as well as an accompanying notice of a proposed revenue procedure (Notice 2019-07) provide much-anticipated guidance on when rental operations qualify for this deduction.
Basics of the 199A Deduction
Beginning in 2018, non-corporate owners of pass-through entities and sole proprietorships are allowed a deduction of up to 20% of qualified business income. In general, qualified business income is income from a domestic trade or business that is not a “specified service business” and is not an item that is typically investment income such as capital gains, interest, or dividends. Qualified business income does not include reasonable compensation paid to the taxpayer by a qualified trade or business.
Is my rental real estate a trade or business?Rental real estate is not automatically considered to be a trade or business. The regulations under 199A require that the business meet the requirements under IRC 162, which generally require that the activity be conducted on a regular, continuous, and substantial basis with the objective of generating a profit. The IRS acknowledged the uncertainty that can exist in the context of rental real estate and the Notice issued provides taxpayers with a safe harbor under which a “rental real estate enterprise” will be treated as a trade or business solely for purposes of 199A. A “rental real estate enterprise” is defined as an interest in real property held for the production of rents and may consist of an interest in multiple properties. The individual or pass-through entity (Partnership or S Corporation) must hold the interest directly or through a disregarded entity. In defining the rental real estate enterprise, taxpayers must decide on whether they will treat each rental property as a separate enterprise or treat all similar properties as a single enterprise. Commercial and residential real estate may not be part of the same enterprise.
To qualify your rental real estate enterprise for the safe harbor, the IRS requires the enterprise to meet the three following requirements for the taxable year:
1. Separate books and records need to be maintained to reflect income and expenses for each rental real estate enterprise;
2. For tax years beginning before 2023, at least 250 hours of “rental services” (see definition below) need to be performed with respect to the enterprise each year. After 2022, at least 250 hours of rental services need to be performed in any three of the five tax years ending with the current tax year; and
3. The taxpayer needs to maintain contemporaneous records documenting the hours of services performed, type of services, and who performed the services (the IRS provided transition relief for 2018, where these records are not required for tax years beginning prior to January 1, 2019).
“Rental services” include advertising, lease negotiation and execution, tenant application work, rent collection, daily operation/maintenance/repair work, real estate management, purchase of materials, and supervision of employees and independent contractors. The rental services are not limited to services performed by the owners but will also include services performed by employees, agents, or independent contractors. Financial and investment management activities are not considered to be rental services for purposes of the safe harbor.
It is also very important to note that triple net leases do not qualify as rental real estate enterprises under this safe harbor (unless the leased property meets the self-rental exception, in which case it automatically qualifies). Additionally, any rental properties used as a personal residence for any part of the year do not qualify.
The final 199A regulations provide a favorable ruling regarding self-rented properties (i.e. the lessor and lessee are under common control) finding that they are presumed to be a trade or business for purposes of the 20% deduction, regardless of whether or not the activity would otherwise be eligible. However, be aware that lessee C-Corps under common control with the rental operation do not qualify for this exception.
Taxpayers or pass-through entities applying the safe harbor must include a statement signed under penalties of perjury identifying that the requirements of the safe harbor are met.
Filing appropriate 1099s is also required of trades or businesses, and should be filed to take a consistent position with respect to the rental real estate enterprise.
What does this all mean for my rental operation?
If the rental operation meets the self-rental exception or the above safe harbor, then it will qualify for the 20% pass-through deduction.
Rental operations outside of the safe harbor and self-rental exceptions may also rise to the level of a trade or business and be eligible for the 20% pass-through deduction. That determination, however, will ultimately come down to the specific facts and circumstances. To help support eligibility for the 20% pass-through deduction, consider taking steps to structure the rental operations to comply with the safe harbor such as taking on maintenance and property management responsibility and avoiding net leases.
In summary, it is important to establish that rental activity is conducted in a trade or business-like manner if you are looking to receive the 199A Deduction. If you are doing some of the things suggested above, you are likely on the right track. You can learn more about the final regulations at irs.gov.