By: Linda Fargo, Tax Manager
Is rental income Qualified Business Income (QBI)? The answer is, it depends.
Section 199A was enacted on December 22,2017 as part of the Tax Cuts and Jobs Act providing a deduction to non-corporate taxpayers of up to 20% of the taxpayer’s qualified business income (QBI), subject to certain limitations and netting rules.
The first step in the calculation of the deduction is for the taxpayer or relevant pass through entity (RPE) to determine whether they are engaged in a trade or business and, if so, how many trades or businesses.
Section 199A(d) defines a qualified trade or business as any trade or business other than a specified service trade or business (SSTB) or the trade or business of performing as an employee. There are two requirements for an activity to be considered a trade or business under Section 162: a profit motive and considerable, regular and continuous activity.
This provision raised the question as to when/whether an investment in a real estate business constitutes a qualified business for the QBI deduction, versus “just” being an investment?
Proposed regulations issued in August 2018 made some things clear:
- Triple-net leases decrease the chances of a rental property rising to the level of a trade or business.
- Real estate investors should keep track of their time (and the time of others) spent working on the real estate business to support their regular and continuous activity.
- Real estate investors owning several units have a greater chance of the activity rising to “trade or business”.
So, merely owning real estate that generates income does not qualify as a trade or business.
On January 18, 2019 Section 199A guidance was released including Notice 2019-07. Notice 2019-07 proposes a safe harbor procedure that would treat a “rental real estate enterprise” as a trade or business solely for purposes of Section 199A.
A safe harbor is just that – not a true bright line test. Facts and circumstances prevail in all cases.
An enterprise that fails to satisfy the requirements of this safe harbor may still be treated as a trade or business for purposes of Section 199A if the enterprise otherwise meets the definition of trade or business in § 1.199A-1(b)(14) on a facts and circumstances, case by case basis.
Under the rules, the rental or licensing of tangible or intangible property to a related trade or business is
treated as a trade or business if the rental or licensing activity and the other trade or business are commonly controlled under Regs. Sec. 1.199A-4(b)(1)(i).
A rental real estate enterprise is defined, for purposes of the safe harbor, as an interest in real property held to produce rents. A rental real estate enterprise may consist of multiple properties. The interest must be held directly or through disregarded entity. Taxpayers either must treat each property held to produce rents as a separate enterprise or must treat all similar properties held to produce rents as a single enterprise. Commercial and residential real estate cannot be combined in the same enterprise.
Safe harbor to qualify Rental Income for the new 20% Qualified Business Income Deduction –
1. Maintain separate books & records;
2. 250 hours or more of rental services performed; and
3. Maintains contemporaneous records including time report logs or similar documents regarding
- Hours of all services performed
- Description of all services performed
- Dates on which such services were performed
- Information on who performed the services.
The contemporary records requirement will not apply to taxable years beginning prior to January 1, 2019.
Rental services include:
- Advertising to rent or lease real estate
- Negotiating and executing leases
- Verifying information contained in 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
Rental services may be performed by owners, employees, agents and/or independent contractors of the owners.
The term rental service does not include financial or investment management activities, such as arranging financing; procuring property; studying and reviewing financial statements or reports on operations; planning, managing, or constructing long-term capital improvements; or hours spent traveling to and from the real estate.
Real estate rented or leased under a triple net lease is also not eligible for this safe harbor.
A taxpayer must include a statement attached to the return on which it claims the section 199A deduction or passes through section 199A information that the requirements have been satisfied. The statement must be signed by the taxpayer, or an authorized representative of an eligible taxpayer or RPE, which states: “Under penalties of perjury, I (we) declare that I (we) have examined the statement, and, to the best of my (our) knowledge and belief, the statement contains all the relevant facts relating to the revenue procedure, and such facts are true, correct, and complete.”
Taxpayers may rely on the safe harbor, which generally applies to tax years ending after 12/31/17, until the proposed Revenue Procedure is published in final form. Notice 2019-7.
This article does not constitute a full and complete discussion of everything that someone would need to know about Section 199A and real estate leasing. The Section 199A rules have a number of requirements that may need to be met. For example, high earner taxpayers who wish to take a 199A deduction attributable to rental income will need to satisfy a wage and/or Qualified Property test that may require that they pay a minimum amount of wages and/or have a minimum amount of depreciable property based upon the original cost of depreciable components.