In December of 2017, the Tax Cuts and Jobs Act was enacted by Congress, which gave us the most sweeping and dramatic changes to the Internal Revenue Code in more than 30 years. The Act created the Internal Revenue Code Section 199A deduction which has the potential to help taxpayers reduce their liabilities with a 20% deduction against their “qualified business income”. Section 199A provides individual taxpayers and certain trusts and estates a deduction for qualified business income from a partnership, limited liability company, S-corporation, sole proprietorship, trust or estate. The deduction applies to tax years beginning after December 31, 2017 and before January 1, 2026.
When it comes to real estate, the new Qualified Business Income (QBI) deduction has further limitations as it only applies against “business income”, not against most passive investments in real estate. QBI does not include investment type income (such as capital gains or losses and most interest and dividends).
In order to qualify for the new 20% QBI deduction as a rental real estate owner, a taxpayer must establish that they are engaged in a “trade or business.” Determining if a taxpayer’s real estate activities qualify as a “trade or business” can be daunting. To be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity, and the taxpayer’s primary purpose for engaging in the activity must be for income or profit. Rental “trade or business” activities must be distinguished from rental “investment activities”. Triple net leases are often associated with an investment activity.
Fortunately, for some taxpayers, the IRS recently released Notice 2019-07, which provides a “safe harbor” to determine when a taxpayer’s real estate activities will qualify as a trade or business for purposes of the Section 199A deduction. Essentially, a taxpayer must perform at least 250 hours of “rental services” in a taxable year with respect to a “rental enterprise”. The taxpayer can elect to combine all their separate rental properties into one “rental enterprise” when applying the 250-hour rule. According to the Notice, in addition to their own hours, taxpayers can count an “agent’s” hours of service (such as property managers and others that are involved in the daily operation, maintenance and repair of the property). Using the safe harbor, it may be possible for even a passive investor to qualify for this tax benefit. Unfortunately, residential and commercial properties cannot be combined and must be treated as separate “rental enterprises” which will make it harder for some taxpayers to qualify.
For taxpayers that own property outright, the safe harbor rules are applied at the individual level. For taxpayers that own property through an eligible pass-through entity, the safe harbor rules are applied at the entity level and reported as such on the taxpayer’s Schedule K-1. These qualified pass-through entities are considered Relevant Pass-through Entities (RPEs) and must determine and report certain information to their owners to determine eligibility for and compute their Section 199A deduction.
In summary, the Section 199A deduction is one of the most significant tax benefits available to real estate investors with qualified activities. It is also one of the most difficult areas in the new tax law due to uncertainty contained in much of the legislation. Please contact us if you have any questions.