The Section 199A 20 percent tax deduction is a gift from lawmakers—literally. You don’t earn this deduction; it’s simply there for you if you qualify.
Under the trade or business rule, your rental property profits can create the deduction. And now, under an alternative rule, you can use the newly created IRS safe harbor to make your rentals qualify for the deduction.
When you meet the new safe-harbor rules, the IRS deems your rental a trade or business with net rental profits that are QBI for the Section 199A tax deduction. But you may not want to use the safe-harbor rules, because they contain some onerous provisions. Also, you may not qualify to use the safe harbor. No problem. You can simply use the second method and win your 199A tax deduction using the existing trade or business tax law rules.
Under the new Section 199A rental real estate safe harbor (and only for this Section 199A safe harbor), each of your rental real estate properties individually or as a group (if you so choose) falls into one of the following categories:
- Residential real estate enterprise
- Commercial real estate enterprise
- Triple net lease real estate
Grouping rule. You (or your pass-through entity) must either
- treat each rental property as a separate enterprise, or
- treat all similar properties as a single enterprise.
Example. You have 10 rentals; eight are residential, and two are commercial. None are triple net lease. With grouping, you have two enterprises: one residential and one commercial.
With grouping of the residential and no grouping of the commercial, you have three enterprises: residential, commercial 1, and commercial 2. (Reminder: You don’t have to use the safe-harbor rules for your rental properties. You can use the historical trade or business rules.)
Solely for Section 199A purposes, the IRS will treat your rental real estate enterprise as a trade or business if you (or your pass-through entity) can satisfy the following requirements:
- You maintain separate books and records that reflect the income and expenses of each rental real estate enterprise.
- You perform 250 or more hours of “rental services” during the tax year.
- You maintain contemporaneous records, including time reports, logs, or similar documents, regarding the following: (i) hours of all services performed, (ii) description of all services performed, (iii) dates on which such services were performed, and (iv) who performed the services. (Note: The contemporaneous records rule does not apply to tax years beginning before January 1, 2019—but don’t let this give you false hope; you still need proof.)
Qualifying defined “rental services” can be done by you, your employees, your agents, and/or your independent contractors. Such services include
- advertising to rent or lease the real estate;
- negotiating and executing leases;
- verifying information contained in prospective tenant applications;
- collecting rent;
- operating, maintaining, and repairing the property;
- managing the real estate;
- purchasing materials; and
- supervising employees and independent contractors.
Rental services that do not qualify for the safe harbor include
- financial or investment management activities, such as arranging financing, procuring property, or studying and reviewing financial statements or reports on operations;
- planning, managing, or constructing long-term capital improvements; and
- hours spent traveling to and from the real estate.
Reminder. The safe-harbor rules above are solely for Section 199A purposes.
Beware. The passive-activity rules for material participation and status as a real estate professional contain many differences from what you see for the Section 199A tax deduction.
Time log. Your number-one important record for obtaining hassle-free tax deductions on your rental real estate is an accurate and provable time log. If you are using the new Section 199A safe harbor, you now have one additional reason to track time spent.
Nonqualifying Real Estate
Triple net lease property does not qualify for the safe harbor. Remember, the safe harbor is not the only method you can use to qualify your rental real estate for the Section 199A tax deduction.
Also, you may not use the safe harbor on real estate that you use as a residence. If you have a vacation home, Section 280A makes that vacation home either a rental property or a residence.
Safe Harbor—No 1099 Issues
If you use the safe harbor, your rental is a business regardless of whether you send 1099s to service providers. In its preamble to the final Section 199A regulations, the IRS notes that the law requires a trade or business to send 1099s to certain service providers.
You may not find it easy getting to the safe harbor. But remember, once you are inside the safe harbor, you have the comfort of knowing that your rental properties are business properties for the possible 20 percent tax deduction under Section 199A. Now, because of the safe harbor, you have a choice:
- use the safe harbor, or
- use the existing tax code trade or business rules to prove that your rental is a trade or business.
And remember, once you are inside the safe harbor, the fact that you did or did not issue 1099s to your service providers is moot for purposes of the Section 199A tax deduction.