Getting the Tax Benefits From Sec. 199A for Rental Real Estate
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!
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How Independent Contractors Should Make Tax Payments
The Right Amount at the Right Time
Filing and paying your taxes looks a lot different as an independent contractor than it does as an employee. Let’s talk about how a contractor calculates their income and tax due, and then we’ll go over the timing of how a contractor should make tax payments.
We Get to Deduct Things?
Contractors have a much easier time deducting work-related expenses than employees do; in fact, starting in 2018, most employees can’t deduct unreimbursed work expenses at all. A contractor can deduct unreimbursed expenses directly against the related income on Schedule C, and only pays income and self-employment tax on the net income amount. Here are some expense items you can likely deduct:
Home Office Expense Tax Write Offs
Most contractors work from home. If you have a part of your house you use to conduct your work as a contractor, you can deduct a portion of the expenses of your home. You can either deduct a flat $5 per square foot (Line 30 of Schedule C), or you can deduct expenses based off the square footage of your office versus the square footage of your home (Form 8829.) Expenses you can allocate in this manner include mortgage interest, real estate taxes, rent, insurance, utilities, repairs and maintenance, and HOA fees. You can also depreciate your home for this purpose and deduct that as a home office expense; see Part III of Form 8829.
Office Expenses Tax Write Offs
You can deduct the expenses of setting up and maintaining an office. Your computer and accessories, software, pens, paper, and other typical office expenses are deductible.
Phone and Internet Tax Write Offs
You can deduct a portion of your cell phone and internet bills for the percentage you use them for business. Be reasonable; the IRS can require you to substantiate the percentage you have chosen.
Licenses and Education Tax Write Offs
If you have a professional license, you can deduct your annual license fees. Whether or not you have a license, you can deduct costs you spend on continuing education, books, and other materials that help you expand your skills related to your contracting job.
Travel Tax Write Offs
If you have to make unreimbursed travel, you can deduct plane tickets, hotel rooms, and 50% of the cost of your meals while you are away from home. You can also deduct driving - for 2018, it’s worth 54.5 cents a mile.
Other Tax Write Offs
The items above aren’t an exhaustive list. The legal standard for a deduction is whether or not it is an ordinary and necessary business expenses - as in, would a reasonable person consider the expense in question? If you have big items you’re not sure about, talk to a CPA and get some extra wisdom.
How Much Taxes Do Independent Contractors Pay?
Contractors pay two different types of tax as part of their annual Form 1040 filing. One is the standard income tax, the same as everyone. The net business income is added to other sources of income (W-2s, interest, dividends, rents, etc.) as part of the calculation of taxable income. The second is the self-employment tax, which is a replacement for both the employer and employee portions of the Medicare and Social Security taxes paid by employees. The self-employment tax is a flat 15.3% on net self-employed business income up to $128,400 for 2018, and 2.9% on amounts above that. This tax is added to your income tax to determine your total tax liability.
Oh, You Expect Me to Pay Now?
Since there is no withholding done when payments for services are made, a contractor has to make tax payments directly to the IRS. Generally, the IRS requires that payments be made in quarterly installments through the year, which are called estimated tax payments. You must pay the lesser of 90% of your current year tax, or 100% of your prior year tax (110% for people with prior year adjusted gross income over $150,000) in four equal installments throughout the year to avoid the estimated tax penalty. The penalty is currently 6% (adjusted for changing ainterest rates) on the daily outstanding underpaid balance, so if you have to choose between paying the IRS or paying off credits cards or other short term debt, the IRS can usually wait.
Any amounts not paid in as estimated tax payments need to be paid by the April 15 filing deadline. Even if you get an extension, an extension of time to file is not an extension of time to pay. Amounts not by paid by April 15 will incur a penalty of 0.5% per month of the underpaid balance, plus interest, so try to pay what you owe by the deadline.