The new tax law, 26 U.S.C. § 162, has left rental real estate owners wondering whether they qualify for the new 20% deduction for qualified business income (QBI). While final regulations indicate that stand-alone, triple-net lease rentals would not qualify for the QBI deduction, there are three alternate paths in which rental activities could qualify for the deduction:
1) As a Section 162 Trade or Business
To qualify for QBI as a Section 162 trade or business, the taxpayer must meet certain facts and circumstances requirements. Case law requires a Sec. 162 trade or business to have a profit motive and pursue considerable, regular, and continuous activity. For example, a hobby would not qualify as a trade or business. The final IRS regulations list several factors to consider when determining whether the rental activity is a Sec. 162 trade or business:
- Type of property rented (commercial vs. residential)
- Number of properties rented
- day-to-Day involvement of the owner or the owner’s agent
- Terms of the lease
- Type and significance of any ancillary services provided under the lease
2) As a Rental to a Related Party
The final regulations state that if the rental activity qualifies as a trade or business, it should be consistently treated as a trade or business under other U.S. Code sections. The taxpayer should also comply with the requirements under Sec. 6041, such as filing required 1099s if assuming the position as a trade or business.
The final regulations offer clear guidance on related party rentals. The rental activity qualifies for the QBI deduction if the rental party rents or leases to an individual or pass-through entity that is commonly controlled. To be considered commonly controlled, the same person or group of persons must own at least 50% of the rental activity and the related trade or business. If the related party is a C corporation, it will not qualify under this rule. Also, if the income of the related party is derived by an activity that is classified as a specified service trade or business (SSTB), the rental activity will treat any rental income from the SSTB as SSTB income when calculating the QBI deduction.
3) As a Rental that Qualifies Under Safe Harbor
A rental activity will also qualify for the QBI deduction if it falls under the safe harbor rule, through Notice 2019-38. To meet the safe harbor requirements, the taxpayer must satisfy the following factors during the taxable year:
- Maintain separate books and records to reflect income and expenses for each rental real estate enterprise
- For rental real estate enterprises that have existed for less than four years: a minimum of 250 hours of rental services are performed per year
- For other rental real estate enterprises: in at least three of the past five years, a minimum of 250 hours per year of rental services were performed
- Maintain contemporaneous records, including time reports, logs, or similar documents, regarding the following:
- Hours of all services performed
- Description of all services performed
- Dates on which such services were performed
- Record of who performed the services
- A statement is attached to a timely-filed, original tax return for each taxable year that the taxpayer relies on safe harbor
These records must be made available for inspection at the IRS’s request. The contemporaneous records requirement applies to taxable years as of January 1, 2020.
To meet the safe harbor rule, taxpayers can combine activities that produce the same type of rent to form a rental real estate enterprise. Thus, commercial rentals can only be combined with other commercial rentals, and residential properties can only be merged with other residential rentals when consolidating activities into a single real estate enterprise.
The self-rental and safe harbor regulations provide clear-cut paths for qualifying for the QBI deduction. Other rental real estate activities may also qualify under Sec. 162 as trade or business activities, however, they need to be analyzed on a case-by-case basis.
If you believe you could qualify for this deduction and need help navigating this area, feel free to call Jessica Corvese at 401-921-2000 or email firstname.lastname@example.org. Be sure to follow us on LinkedIn to stay informed on the latest tax updates.