By Judith Herron, CPA
The tax treatment of rental properties became a bit more challenging with passage of the 2017 Tax Cuts and Jobs Act (tax reform). If you are among the more than 20 million taxpayers who report rental income on your tax return, having a clear strategy for figuring out your tax liability is a must before you begin 2019 tax preparation.
The area in question is the new Section 199A deduction. Taxpayers who fully qualify can exclude 20% of rental profit from taxable income. That’s the good news. The bad news is that there are several conditions that limit or exclude a taxpayer’s ability to take the deduction. First (for tax year 2019), the deduction fully applies only to those with taxable incomes below $321,450 for married filing jointly and $160,700 for other taxpayers. In addition, the law requires your rental property to be considered a trade or business under Section 162 of the Internal Revenue Code. This is where it gets tricky. Rental income flows through many tax returns in a way that is different than other business income. That opens the door to the idea that maybe the IRS doesn’t consider some types of rentals a trade or business. Making things more confusing, what constitutes a trade or business isn’t defined in the Internal Revenue Code. There is a Supreme Court case related to Section 162 that provides often-cited guidance. The opinion says to qualify as a trade or business under this section, the taxpayer must devote regular, continuous, and substantial efforts to the activity with the intention of making a profit. But it’s not clear exactly how much effort is considered regular, continuous, and substantial.
General CPA concerns and warnings about this lack of clarity did move the IRS to create a “safe harbor” for rentals associated with Section 199A. But if your rental property doesn’t meet the safe harbor criteria, you may still be eligible for the deduction. If you do meet the criteria, then you can be confident the IRS considers your rental enterprise a business. According to Revenue Procedure 2019-38, here is what a taxpayer or pass-through entity must have in place to qualify:
- Separate books and records to reflect income and expenses for each rental enterprise. These records must be in real time and include details on what activities were performed, how long it took, and who did them.
- For rental enterprises in existence less than four years, 250 or more hours of rental services must be performed per year. For others, 250 or more hours of rental services must have been performed in at least three of the past five years. The IRS says these hours may include services such as maintenance, repairs, rent collection, paying expenses (and making sure you file 1099 forms for service providers) as well as efforts to rent the property. However, hours spent on things such as arranging financing, purchasing property, reviewing financials, and traveling to and from the real estate do not count.
If you do all this, you also have to attach a special signed statement to your tax return saying that you meet the criteria for the safe harbor. Before you attach that statement, though, there are other items to check. To start, you cannot get the Section 199A deduction if you are a corporation. The new law lowered the maximum corporation tax rate to 21%, so corporation owners don’t get an additional break. The Section 199A regulations only apply to business activity that flows through to individuals and some trusts and estates.
Also excluded from the safe harbor are real estate used by the taxpayer as a residence for part of the year and property where a portion is treated as a specified service business. (Specified service businesses include consulting, medicine, accounting, and law, which have their own rules.)
Triple net leases are excluded from the safe harbor. If a business owner of a flow-through entity also is the landlord holding the triple net lease that automatically qualifies as a trade or business in Section 199A, no safe harbor is needed. If it is not a self-rental, there is a question about effort: the whole point is the tenant handles almost everything. If the rental involves a specified service business, remember they get different treatment throughout Section 199A.
The potential benefits and actual complexity around applying Section 199A to your rental businesses might require you to either start memorizing hundreds of pages of regulations now, or you can call your CPA to discuss how this deduction might apply in your case. Because it is such a big deduction, you don’t want to get it wrong. Make the effort to get it correct, and reach out to your local CPA to help you make the right call.
Judith Herron, CPA, is an accountant for Markovitz Dugan & Associates in Pittsburgh. She can be reached at firstname.lastname@example.org.
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