QBI in a nutshell
The 2017 tax law added Section 199A to the Internal Revenue Code. It generally allows partnerships, limited liability companies (LLCs), S corporations and sole proprietorships to deduct as much as 20% of QBI received. The deduction is subject to several significant limitations.
Related Read: “IRS Provides QBI Deduction Changes Just In Time for Filing“
One of the key requirements to qualify for the deduction is that the income must be from a “trade or business.” This is a term of art in the tax law. The concept is generally what you think of as a business, but there is no succinct definition.
Many taxpayers involved in rental real estate activities were uncertain whether those activities rise to the level of a “trade or business” or were merely “income producing activities.” Prior to the new law, the distinction was of less significance.
The IRS provided the safe harbor to give some comfort to individuals and entities that own rental real estate that their activities will be treated as a “trade or business.” If so, the income from the rental activity can qualify for the QBI deduction.
The safe harbor applies to qualified “rental real estate enterprises.” For purposes of the safe harbor only, the term refers to a directly held interest in real property held for the production of rents. It may consist of an interest in a single property or multiple properties.
The individual or entity can treat each interest in a similar property type as a separate rental real estate enterprise – or treat interests in all similar properties as a single enterprise. Properties are “similar” if they are in the same rental real estate category (residential or commercial). In other words, an enterprise can hold only commercial real estate or it can hold only residential properties.
Notably, the guidance provides that an interest in mixed-use property may be treated as a single rental real estate enterprise or bifurcated into separate residential and commercial interests.
Once you elect to treat interests in similar properties as a single enterprise, you must continue to treat interests in all properties of that category — including newly acquired properties — as a single enterprise for as long as you continue to use the safe harbor.
Safe harbor requirements
The final guidance clarifies the requirements you must fulfill for each tax year that you wish to claim the safe harbor. Requirements include:
- Keeping Separate Books and Records
You must maintain separate books and records reflecting income and expenses for each rental real estate enterprise. If the enterprise includes multiple properties, you can use consolidated books to meet this requirement.
- Performing Rental Services
For enterprises in existence less than four years, at least 250 hours of rental services must be performed in each of the four years. Otherwise, the safe harbor requires at least 250 hours of rental services per year in any three of the five consecutive tax years that end with the tax year of the safe harbor. The rental services may be performed by owners or by employees, agents or contractors of the owners. Rental services include:
- Advertising to rent or lease the property;
- Negotiating and executing leases;
- Verifying tenant application information;
- Collecting rent;
- Performing daily operation, maintenance and repair of the property, including the purchase of materials and supplies;
- Managing the property; and
- Supervising employees and independent contractors.
- Maintaining Contemporaneous Records
The safe harbor requires contemporaneous records describing the service, associated hours, dates and the individuals who performed the service. For example, if services are performed by employees or contractors, you can provide a description of the services, the amount of time the employee/contractor generally spent performing those services and time, wage or payment records for the individuals. The contemporaneous records requirement does not apply to tax years beginning before January 1, 2020. However, the IRS cautioned that taxpayers still must establish their right to any claimed deductions for any tax years, so documentation – contemporaneous or not – is still required to establish the 250 hours prior to January 1, 2020.
- Attaching a Tax Return Statement
To claim the safe harbor, you must attach a statement to your original tax return (or, for the 2018 tax year only, on an amended return) for each year you rely on the safe harbor. If you have multiple rental real estate enterprises, you can submit a single statement listing the requisite information separately for each.
Excluded real estate arrangements
The safe harbor is not available for all rental real estate arrangements. The guidance excludes:
- Real estate used as a residence by the taxpayer (including an owner or beneficiary of a pass-through entity);
- Real estate rented or leased under a triple net lease (see below for further guidance);
- Real estate rented to a commonly controlled business; or
- The entire rental real estate interest if any part of it is treated as a specified service trade or business (SSTB) for purposes of the QBI deduction. (SSTBs with taxable income above a threshold amount do not qualify for the deduction.)
Triple Net Lease
One of the most interesting changes from the proposed rules is that the description of “triple net lease” has been slightly narrowed. The original description was:
“This includes a lease agreement that requires the tenant or lessee to pay a portion of the taxes, fees and insurance, and to be responsible for maintenance activities allocated to the portion of the property rented by the tenant.”
The new description is:
“… a triple net lease includes a lease agreement that requires the tenant or lessee to pay taxes, fees and insurance, and to pay for maintenance activities for a property in addition to rent and utilities.”
Because the new description applies to less arrangements, more leasing arrangements may qualify for the safe harbor.
Alternative to the safe harbor
As with all safe harbors, this one does not establish the only way that a real estate activity can qualify as a “trade or business.” In fact, the Revenue Procedure clearly states that taxpayers who do not qualify for the safe harbor may still establish that rental real estate is a “trade or business” by applying the existing standards under Section 162.
The final safe harbor rules apply to tax years ending after December 31, 2017, so you may want to evaluate whether you need to amend your 2018 tax return. In addition, you may need to evaluate whether the safe harbor is helpful (and available) to you each year. We can help.
For more information, contact Thomas Vance at 312.670.7444. Visit orba.com to learn more.