The Tax Cuts and Jobs Act of 2017 (TCJA) provides a new deduction the likes of which I have never seen. The Qualified Business Income Deduction (pursuant to Internal Revenue Code Section 199A) provides a 20 percent deduction of profits from any trade or business. The purpose of this article is to provide some clarity to the real estate world pertaining to the IRS requirements for real estate rental profits to qualify for this deduction. Obviously, this is a complex deduction and the services of competent tax advisors is a must.
Since December 22, 2017, the date that the TCJA became effective, and throughout 2018, the tax professional community was uncertain as to how this deduction affected rental property profits. Thankfully, the IRS clarified the issue for us this January.
Safe Harbor:
On January 18, 2019, the IRS issued Notice 2019-07, which provides a safe harbor for investors in real estate rentals. An IRS safe harbor provides guidance, that if followed, will assure the tax- payer that the IRS has little interest in conducting an audit on the issue.
The safe harbor covers both residential rental property and commercial, but specifically excludes properties subject to a triple net lease.
The safe harbor requires very specific record keeping of real estate property owners beginning January 1, 2019. Due to the date of the safe harbor, the extensive record keeping requirements do not apply to 2018.
The safe harbor requires that rental real estate owners must spend 250 hours or more per year on their real estate rental enterprise. A rental real estate enterprise may consist of one property or multiple properties. (I recommend the latter.)
In counting the 250 hours, the owner may include time that they personally spend on the properties, as well as the time spent by employees, managers, or independent contractors. The safe harbor specifically lists the activities for which time can be counted, and basically includes everything an owner, manager, or independent contractor will spend time on, except for analyzing financial reports, construction or major renovation hours, and time spent traveling to and from the property or properties.
I believe those real estate investors with one or two rental properties are going to have difficulty in coming up with 250 hours per year. In addition, if your real estate rentals consistently show losses on your tax return, then the safe harbor is of no use to you. Only rental real estate owners with enough properties and profits will truly benefit by the IRS Notice, if the owners are willing to take the time to keep the necessary records.
This safe harbor is not to be taken lightly, as the IRS requires a statement under penalty of perjury to be attached to the tax return claiming this safe harbor. I recommend that all property owners using this safe harbor read IRS Notice 2019-07 carefully.
Chris Bird, CFP is a tax expert and national lecturer on individual and corporate income taxes, and real estate issues.