The massive tax legislation signed over a year ago, the Tax Cuts and Jobs Act (TCJA), authorized a brand-new deduction for qualified business income (QBI) of pass-through entities and sole proprietors. This deduction under Section 199A of the tax code provides opportunities for a wide range of taxpayers, but has also caused confusion, especially as it relates to triple net leases and other real estate activities.
The 199A deduction is first available on 2018 returns. Fortunately, the IRS recently issued some-much needed guidance in the form of new final regulations.
Background: The TCJA allows a qualified taxpayer to deduct up to 20% of QBI earned during the tax year. However, the deduction is phased out at certain income levels, depending on whether or not you work in a “specified service trade or business” (SSTB). This includes most personal service providers like attorneys, physicians and consultants.
But the law still leaves room for interpretation. Notably, if you participate in a rental real estate activity, it may not be clear if you qualify for the 199A deduction. There is no bright-line indicator in the TCJA, but now the IRS has established a new safe-harbor rule.
How it works: Under the new regs, a rental activity (including multiple rental activities where the taxpayer elects to combine them in a single enterprise) is treated as trade or business for 199A deduction purposes if these requirements are met:
- You maintain separate books and records for each rental activity (or the combined enterprise);
- You perform 250 hours or more of rental services for the activity (or combined enterprise); and
- You maintain contemporaneous records showing (1) hours of services performed, (2) a description of all services performed, (3) dates on which services are performed and (4) identities of the parties performing the services.
Rental services include advertising rentals; negotiating and executing leases; verifying tenant applications; collecting rent; daily operations and maintenance; real estate management; purchase of materials; and supervision of employees and independent contractors. The services may be performed by the owner(s), employees or agents and/or independent contractors.
On the downside, certain rental activities are excluded from the safe-harbor rule. This includes two key situations.
- You use the real estate as a residence for any portion of the year; and
- You rent out the property on a triple net lease basis.
The IRS defines a “triple net lease” as a lease agreement requiring the tenant or lessee to pay (a) taxes, fees and insurance, (b) expenses for maintenance and (c) rent and utilities. These requirements are often stated in rental agreements.
However, the final regulations preserve a special “self-rental” exception from the proposed regulations. Under this exception, rental or licensing of property to a related trade or business is treated as a trade or business if the activities are commonly controlled (i.e., more than 50% common ownership), even if the rental is on a triple net lease basis.
Practical advice: Consult with your professional advisers for ways to maximize the tax benefits for your real estate activities.