The Tax Cuts and Jobs Act of 2017 introduced Section 199A, the Qualified Business Income deduction. A new deduction available on the profits of sole proprietorships, partnerships, S Corporations and some trusts and estates. This tax benefit is aimed at reducing the tax burden of US based business owners that do not receive a benefit from the reduction of the C-corporation tax rate from 35% to 21%. Section 199A provides for a 20% deduction on the taxpayer’s combined qualified business income subject to certain phase-outs and limitations.
The Final regulations issued on January 18, 2019 provide some guidance on what income qualifies for this deduction, but there is still some ambiguity surrounding whether an interest in real property held for the production of rents is considered a qualified trade or business for the purpose of Section 199A. Owners of rental property may want to take additional steps to reinforce their position that the activity is considered a trade or business, and therefore eligible for an up to 20% deduction on that income.
A Safe Harbor was introduced through IRS Notice 2019-07 that provides for a proposed revenue procedure that specifically addresses criteria that would allow a rental activity to be eligible for the 199A deduction.
1. “Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise”. The more detailed your books and records are, the stronger your argument is for treating your rental activity as a trade or business. If you have multiple rental properties, it is helpful to keep separate books and records for each property.
2. “For taxable years beginning prior to January 1, 2023, 250 or more hours of rental services are performed per year with respect to the rental enterprise”. Rental services include:
- 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
These services can be performed by owners, employees, agents, and independent contractors of the owners.
3. “The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents”. Keeping a record of the hours of work performed on a property can be just as important for claiming the 199A deduction as actually performing the work. Specific documentation should include:
- Hours of all services performed
- Description of the services performed
- Dates on which such services were performed
- Who performed the services
It is also important that the records are maintained on a contemporaneous basis, rather than after the fact.
Specifically excluded from this safe harbor is real estate used by the taxpayer as a residence for any part of the year and real estate rented or leased under a triple net lease. The safe harbor is intended to provide a set of circumstances that would clearly qualify for the 20% deduction under section 199A. It is still possible for a rental activity to be considered a qualifying trade or business without having met the standards of the safe harbor by looking at the individual facts and circumstances of the rental activity - profit motive, continued and regular involvement.
Determining whether your rental activity qualifies for a 20% deduction under Section 199A is a complex task that we encourage you to discuss with your trusted HKG tax professional.