The Treasury recently delivered clarity and good news for owners of rental real estate regarding available deductions for rental income under the 2017 Tax Cuts and Jobs Act.
The Tax Cuts and Jobs Act introduced many significant changes to the tax code. One of the most notable provisions was IRC section 199A, which provides an income tax deduction for many non-corporate taxpayers equal to 20% of income from a “qualified trade or business.” Although many types of commercial activity clearly fall within this definition, it was unclear whether income from rental real estate would qualify.
Under newly issued IRS Notice 2019-7, owners of rental real estate are provided the following list of “safe harbor” conditions which, if met, will ensure the rental income will be considered coming from a “qualified trade or business” eligible for the 20% income tax deduction:
(1) Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise;
(2) At least 250 hours of rental services are performed each year;
(3) Taxpayer maintains contemporaneous records, including time reports, logs, or similar documents regarding the nature of the rental services (who performed the service, hours spent, description of services), and such records made available for IRS inspection upon request.
The Treasury Regulation further provides that the 250 hours of “rental services” will include services performed by owners, their employees, and their independent contractors for property maintenance, repairs, rent collection, payment of expenses, provision of services to tenants, and efforts to rent the property. Not included are investment-type activities, such as obtaining financing, making capital improvements, acquiring property, evaluating financial performance, and commuting to rental properties.
Taxpayers who meet the above conditions will fall within the “safe harbor” meaning their rental income will be considered income from a qualified trade or business. However, there are two major exceptions to the safe harbor:
(1) Real estate used by the taxpayer as a residence for any part of the year is not eligible for the safe harbor;
(2) Real estate subject to a “triple-net” lease is not eligible for the safe harbor.
Even if the conditions of the safe harbor are not met, it is possible the rental income can still be considered from a qualified trade or business. As a technical matter, under IRC section 199A (the statute providing the 20% deduction), a “trade or business” will have the same meaning as a “trade or business” under IRC section 162 (the statute regarding deductions of business expenses). This definition was the subject of the U.S. Supreme Court case Commissioner v. Groetzinger, where the court held that a gambler making wagers on greyhound races was engaged in a “trade or business” since the gambler was gambling full-time and was motivated by profit in the activity. The IRS website currently memorializes this reasoning simply as: “a trade or business is generally an activity carried on for a livelihood or in good faith to make a profit.” Taxpayers who do not meet the conditions of the “safe harbor” will bear the burden in proving their particular rental activity constitutes a qualified trade or business.
While the safe harbor offers clarity, it may prove more valuable for owners of rental real estate in coming years, presuming many taxpayers will not have kept “contemporaneous records” of their rental activities during 2018 and will be better positioned to document their rental activity moving forward. Also, it should be noted that meeting the “trade or business” requirement (whether under the safe harbor or otherwise) is only one of several conditions for the 20% deduction under IRC section 199A, which includes limitations or phase-outs based on taxpayer’s income, W-2 wages paid, and basis of property.
GVM Law LLP has assisted clients with estate planning, business, and tax matters for over 40 years. For more information please contact Jeffrey Stephens or one of the other attorneys in the Roseville or Napa Valley offices.
Written by- Jeffrey Stephens