The Tax Cuts and Jobs Act (also known as the Trump tax reform) implemented Internal Revenue Code Section 199A, which offers a deduction of up to 20% of the income for most businesses. Historically, whether rental real estate has met the tax code definition of a “trade or business” has not been a question of much substance, since rents are not subject to the self-employment tax. However, since the 20% haircut is only available for businesses, it’s important that rental real estate owners make sure that they will qualify as such.
During January, the IRS has released regulations outlining a safe harbor that rental operators can use to document their qualification as a business. Even for those owners that can’t meet the safe harbor, these regulations reveal how the IRS is going to think about Sec. 199A for rentals. The IRS has specifically declined to take a positioning deeming all rental activities to be businesses.
The Tax Cuts and Jobs Act safe harbor has three requirements:
(1) The owner must maintain separate books and records for the real estate enterprise. A real estate enterprise can be composed of multiple properties; however, an enterprise, for this purpose, cannot contain both residential and commercial properties, and properties subject to a triple net lease or that the taxpayer uses personally for more than 14 days in the year cannot be included.
(2) 250 hours of rental services must take place within the enterprise each year. These services can be performed by the owner, employees, or, crucially, by independent contractors. Rental services include advertising, leasing, verifying applications, collection of rent, repairs and maintenance, management, purchasing materials and supplies, and supervision of employees and contractors. However, rental services do not include property acquisition, arranging financing, reviewing financial statements, planning or constructing long-term capital improvements, or travel to and from the property.
(3) Starting for 2019, the owner must keep contemporaneous records detailing the dates and hours services were performed, description of services performed, and names of who performed the services. This requirement is waived for tax year 2018.
This safe harbor will require some adjustment on how rental operators, management companies, and subcontractors track their time. Owners will have to be proactive to get time information from people they hire, so that they will be able to reach the required 250 hours (roughly five hours a week). Owners are required to include a statement verifying, under penalty of perjury, that they have the required records, and the risk of audit in upcoming years could be significant. It will be critical to maintain timely, accurate records to avoid having any issues with the IRS.
Failure to meet the safe harbor does not automatically disqualify rental owners from taking advantage of Sec. 199A. The determination of whether a rental activity is a business is made by the facts and circumstances of each unique situation. Factors at play include the type and number of properties rented, the owner’s day-to-day involvement, any ancillary services provided under the lease, and the terms of the lease.
If you don’t believe you will reach the safe harbor for 2019, but you might be close, there are things you can do. While most leases for single-family residences pass lawn maintenance to the tenant, the landlord can add an extra 25 to 50 hours a year to the tally by hiring their own lawn service and passing the cost to the tenant. Other repairs and maintenance that have been contracted out can be done by the owner or by relatives, typically for lower cost and more hours.
Minor repairs and maintenance that would be done in future years can be accelerated into 2019, especially if the owner anticipates acquiring more properties. The owner can spend additional time studying market comparisons to set appropriate rents.
It will be critical for landlords with fewer properties to capture all their eligible time spent on their rental activities, and to not be shy about getting names and hours worked from contractors hired to maintain their properties.
Accurate, easy-to-follow records are the best defense against any IRS issues, so take advantage of this safe harbor and get that 20% deduction!