Rental Activities Qualify for New Tax Break
ANITA S. WESCOTT, CPA
The Tax Cuts and Jobs Act (TCJA) has created a significant new tax deduction for qualified business income (QBI) for so-called “pass-through” entities for 2018 through 2025. But, it also created uncertainty about whether owners of rental real estate were eligible for the deduction. Recent IRS guidance addresses this gap with a proposed safe harbor that allows certain real estate enterprises to qualify as a business for purposes of the deduction.
Claiming the deduction
Qualifying pass-through entities, including partnerships, limited liability companies (LLCs), S corporations and sole proprietorships, are generally allowed to deduct up to 20% of QBI. QBI means the net amount of income, gains, deductions and losses (excluding reasonable compensation, certain investment items and payments to partners for services rendered).
Related Read: “IRS Provides Final QBI Real Estate Safe Harbor Rules”
A wage limit begins phasing in if your taxable income for 2019 exceeds $160,700 for single people, $321,400 for married people who file jointly or $160,725 for married people who file separately. Under the limit, your deduction cannot exceed the greater of 50% of the business’s W-2 wages or 25% of the W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of qualified business property.
In partnerships or S corporations, each partner or shareholder is treated as having paid W-2 wages for the tax year in an amount equal to that individual’s allocable share of the W-2 wages paid by the business for the tax year. The UBIA of qualified property generally is the purchase price of tangible depreciable property which the business held at the end of the tax year.
The application of the wage limit phases in for individuals with taxable income exceeding the threshold amount over the next $100,000 of taxable income for married individuals filing jointly or the next $50,000 for other individuals. It phases in completely when taxable income for 2019 exceeds $210,700 for single people, $421,400 for married people who file jointly and $210,725 for married people who file separately.
This deduction generally cannot exceed 20% of your taxable income less any net capital gains. So, for example, if the QBI for a married couple with no net capital gains is $400,000 and the couple’s taxable income is $300,000, the deduction is limited to 20% of $300,000, or $60,000. There is a more involved calculation if 20% of the QBI is less than taxable income. The deduction is 20% of the QBI plus 20% of qualified REIT dividends plus 20% of publicly-traded partnership income, with the total subject to the 20% taxable income limit.
The QBI deduction applies to taxable income and does not factor in when computing adjusted gross income (AGI). It is available for both itemizing and non-itemizing taxpayers, as well as those paying the alternative minimum tax.
Qualifying for the safe harbor
Owners of rental real estate received welcome news when the IRS issued final regulations for the QBI deduction along with additional guidance. The guidance (IRS Notice 2019-07) details the proposed safe harbor that would allow certain real estate enterprises to claim the deduction. Taxpayers can rely on the safe harbor until a final rule is issued.
Generally, the safe harbor provides that eligible rental businesses (see “What Counts as a Rental Real Estate Enterprise?”) can claim the deduction if:
- Separate books and records are kept to reflect income and expenses for each rental real estate enterprise;
- For taxable years through 2022, at least 250 hours of rental services are performed each year for the enterprise; and
- For tax years after 2018, the taxpayer maintains contemporaneous records showing the income and expenses, the hours of all services performed, the services performed, the dates they were performed and who performed them.
For taxable years after 2022, the 250 hours of rental services may be performed in any three of the five consecutive taxable years that end with the taxable year (or, for enterprises held less than five years, in each year).
The hours-of-services requirement may be satisfied by work performed by owners, employees or contractors. Qualifying work includes maintenance, repairs, rent collection, expense payment, negotiating and executing leases and efforts to rent out property. Investment-related activities — for example, arranging financing, procuring property and reviewing financial statements — do not qualify.
The safe harbor is not available for property leased under a triple net lease that requires the tenant to pay all or some of the real estate taxes, maintenance, and building insurance and fees. It also does not apply to property the taxpayer uses as a residence for any part of the year.
What counts as a rental real estate enterprise?
The safe harbor for being treated as an eligible business for qualified business income (QBI) deduction purposes is available only to “rental real estate enterprises.” The IRS notice defines this as an interest in real property held to produce rents and says it may consist of an interest in multiple properties.
The taxpayer — whether an individual, a partnership or an S corporation — must hold the interest directly or through a disregarded entity (an entity that is not considered separate from their owners for income tax purposes, such as single-member limited liability companies). Taxpayers can either treat each property as a separate enterprise or treat all similar properties as a single enterprise. You cannot, however, treat commercial and residential real estate as part of the same enterprise. And, you cannot change the treatment from year to year absent a significant change in circumstances.
Just an appetizer
The QBI deduction is just one of many potential perks in the TCJA for real estate businesses. But, numerous rules and restrictions apply. Fortunately, your ORBA advisor can help you navigate the details.
Tax Tips for Real Estate
TANYA GIERUT, CPA
Minimizing taxes on trusts
If you have established or plan to establish one or more trusts as part of your estate plan, be sure to evaluate the tax implications. Trusts have grown in popularity, but many people do not understand that there are various types of trusts which each have their own set of rules. Trusts can hold real estate, but you should take a step back and consider if that is the best option.
For 2019, trusts enter the highest tax bracket (37%) when their income tops $12,750, so it is important to consider steps to reduce the tax bite. Married taxpayers filing jointly in 2019 hit the top bracket of 37% when income is greater than $612,350.
Potential strategies include the following:
- Use Grantor Trusts
These trusts are designed so that the trust’s income is taxed to the grantor, not the trust.
- Avoid Taxable Investments
Shifting the trust’s investments to tax-exempt or tax-deferred investments, such as municipal bonds or life insurance, can reduce the burden of high income taxes. Be wary; state taxes may still apply.
- Distribute Income
Generally, non-grantor trusts are taxed only on undistributed taxable income which can be avoided if the trust distributes income to its beneficiaries.
Keep in mind that shifting income to the grantor or beneficiaries is effective only if they are in a lower tax bracket than the trust.
Donating stock to charity
If you are charitably inclined, consider donating appreciated stock, instead of cash, to charity. So long as you have held the stock for more than a year and itemize deductions on your tax return, you will be entitled to deduct the stock’s fair market value (up to 30% of your adjusted gross income). Plus, you will avoid capital gains taxes that you would have paid had you sold the stock and donated the cash. The charity, as a tax-exempt entity, can sell the stock tax-free.
Reinvesting capital gains in Qualified Opportunity Zones
The 2017 Tax Cuts and Jobs Act has created a new tax savings vehicle that helps promote economic development and job creation in distressed areas across the United States by reinvesting your capital gains into a qualified opportunity fund (QOF). Your gain will be deferred and if you hold onto the investment long enough (five, seven or ten years), you can reduce or exclude the gain completely. Similar to a like-kind exchange, there are strict rules the taxpayer must adhere to in order to qualify for this tax incentive. Please contact your tax advisor to learn about all the rules before investing in a qualified opportunity fund.
Related Read: “Using Cost Segregation for Like-Kind Exchanges”