Rental Real Estate: Determining if a Property Is a Business or an Investment
MICHAEL J. KOVACS, CPA
If you own rental real estate, its classification as a trade or business rather than an investment can have a big impact on your tax bill. The distinction is especially important because of the 20% Section 199A deduction for certain sole proprietors and pass-through entity owners.
The 199A deduction is available for qualified business income (QBI), which can come from an eligible trade or business, but not from an investment. So, assuming you otherwise meet the requirements, qualifying your rental real estate activities as a trade or business may yield substantial tax savings. Fortunately, an IRS Revenue Procedure establishes a safe harbor.
A brief review
The 199A deduction is too complex to cover fully here. In general, it allows owners of sole proprietorships and pass-through entities — partnerships, S corporations and generally limited liability companies (LLCs) — to deduct as much as 20% of their net business income, without the need to itemize.
Eligible owners are entitled to the full deduction so long as their taxable income does not exceed an inflation-adjusted threshold (for the tax year 2021, $164,900 for singles and heads of households; $329,800 for joint filers). Above the threshold, the deduction may be reduced or eliminated for businesses that perform certain services or lack sufficient W-2 wages or depreciable property.
Rental real estate guidance
According to the IRS, for purposes of the 199A deduction, an enterprise is a trade or business if it qualifies as such under Internal Revenue Code Section 162. That section does not expressly define “trade or business” — it is determined on a case-by-case basis based on various factors. Generally, a trade or business is an activity conducted “on a regular, continuous and substantial basis” with the aim of earning a profit.
Uncertainty over whether rental real estate qualifies, especially for taxpayers with one or two properties, prompted the IRS to issue Revenue Procedure 2019-38 to establish a safe harbor. Under the Revenue Procedure, a rental real estate enterprise (RREE) is deemed a trade or business if the taxpayer (you or a “relevant pass-through entity” in which you own an interest):
- Maintains separate books and records for the enterprise;
- Performs at least 250 hours of rental services per year (for an enterprise that is at least four years old, this requirement is satisfied if you meet the 250-hour test in at least three of the last five years);
- Keeps logs, time reports or other contemporaneous records detailing the services performed; and
- Files a statement with his or her tax return.
The Revenue Procedure lists the types of services that count toward the 250-hour minimum and clarifies that they may be performed by the owner or by employees or contractors. It also defines an RREE as one or more rental properties held directly by the taxpayer or through disregarded entities (for example, a single-member LLC).
Generally, taxpayers must either treat each rental property as a separate enterprise or treat all similar properties as a single enterprise. For example, commercial and residential properties cannot be combined in the same enterprise.
Related Read: IRS Provides Final QBI Real Estate Safe Harbor Rules
There may be opportunities to restructure rental activities to take full advantage of the safe harbor. For example, Marilyn owns a rental residential building and a rental commercial building and performs 125 hours of rental services per year for each property. As noted, she cannot combine the properties into a single enterprise, so she does not pass the 250-hour test.
But, let us say that she exchanges the residential building for another commercial building for which she provides 125 hours of services. Then she can treat the two commercial buildings as a single enterprise and qualify for the safe harbor (provided the other requirements are met).
Do not try this at home
The tax treatment of rental real estate is complex. To take advantage of the 199A deduction or other tax benefits for rental real estate, consult your ORBA tax advisor.
Sidebar: Are you a real estate professional?
Ordinarily, taxpayers who “materially participate” in a trade or business are entitled to deduct losses against wages or other ordinary income and to avoid net investment income tax on income from the business. The IRS uses several tests to measure material participation. For instance, you materially participate in an activity if you devote more than 500 hours per year, or if you devote more than 100 hours and no one else participates more.
However, rental real estate is generally deemed to be a passive activity — that is, one in which you do not materially participate — regardless of how much time you spend on it. There is an exception, however, for “real estate professionals.”
Related Read: Real Estate Professional — Do I Qualify?
To qualify for the exception, you must spend at least 750 hours per year — and more than half of your total working hours — on real estate businesses (such as development, construction, leasing, brokerage or management) in which you materially participate. The hours you spend as an employee do not count unless you own at least 5% of the business.
Staying on Top of Preventive Maintenance
JUSTIN SYLVAN, CPA, MST
Performing routine building inspections and maintenance on a regular basis can help you avoid unnecessary headaches. Setting a consistent, ongoing schedule is the first step.
Related Read: Performing Preventive Maintenance is Key
Create and maintain an “inventory” that describes each building component fully. This should include the manufacturer, location within the property, details about the purchase and existing warranties and, if applicable, operating procedures. The inventory should also state where to obtain needed parts and service and contain a summary of all repairs and/or replacements. This schedule will help management quickly assess the condition of fixed assets and help transition the task if a new person is put in charge of repairs and maintenance.
Start with the exterior of your building. Check the foundation walls (including waterproofing) and window seals (repairs and possible replacements). Inspect the fascia and soffits, and take a look at the condition of the exterior painting. Finally, review the grading and drainage around the building.
To ensure that your maintenance program covers all of the bases, regularly inspect every piece of equipment on each property. This includes elevators, HVAC systems, pumps and motors. Be sure to include structural components, such as roofs and supports.
Interior “hotspots” that deserve attention include moisture control systems, drywall installation and repair, mechanical systems and plumbing and electrical repairs. Finally, check on the conditions of the interior painting and the wear and tear of any carpeting, noting possible replacement.
Schedule inspections and repairs
Determine the types of inspections and preventive maintenance that should be performed on each piece of equipment and structural component. Note how frequently these tasks should be done. You will need to check some maintenance items weekly, while you can inspect others less often. Program routine maintenance reminders into an electronic calendar — or write them in a day planner — to stay on schedule.
For equipment items, develop a schedule that outlines when each item needs to be cleaned, lubricated, serviced or overhauled. Keep a list of spare parts that should be kept on hand. For structural items, add a “to-do” list for periodic inspections related to painting, patching or similar maintenance issues.
Work with your property manager and maintenance supervisor to develop a realistic schedule for needed tasks. Create a formal schedule for fixed asset repair and maintenance and assign your property manager to update this schedule. Create checklists that facilitate daily, weekly, monthly or even seasonal reports. Having a maintenance checklist with reminders about when a specific system needs to be serviced is vital to make sure you will not miss anything. Then implement a system for issuing work orders and monitoring task completion.
Assess how much time the preventive maintenance program will require and develop cost estimates that are realistic for both the budget and level of work involved. In some cases, it may be cheaper to replace an outdated asset, rather than maintain it.
For example, many older buildings use old electrical or plumbing systems that might be expensive to maintain. You may be able to reduce monthly utility bills by replacing the entire system. Moreover, equipment will likely last longer, deferring replacement costs and major equipment breakdowns will be less frequent.
The building owner might also benefit from a tax credit for energy-saving equipment, together with increased depreciation write-offs, in the event of an equipment upgrade. But, before you start upgrading, evaluate whether the financial benefits of the upgrades, over the long term, outweigh the costs.
Maintaining accurate records will help determine whether you can save time, money — or both — by simply performing certain maintenance activities less frequently, or whether certain items should be inspected more often. Keeping good records can also help verify whether maintenance personnel are performing needed tasks to your satisfaction.
When was the last time you performed regular maintenance of your buildings? If you do not already have a regular maintenance schedule, now is the time to start one. Preventative maintenance can save considerable amounts of money by tending to the small things today. This will help protect your investment and ensure your property continues to bring you the returns you expect.