Under the new tax reform, Section 199A has been established to provide qualifying individual taxpayers and pass-through entities with a tax deduction of up to 20 percent of qualified business income (QBI). Section 199A also creates a “safe harbor” for owners of rental properties. If the filer qualifies for the safe harbor, the filer’s rental properties are considered as trades or businesses. This means that income generated from these trades or businesses may be subjected to the 20 percent tax deduction.
Must I use the safe harbor rules?
No. In fact, some filers may not qualify for the safe harbor. There is an alternative. You could use the historical trade or business rules instead.
What is the safe harbor?
The safe harbor rule defines a rental real estate enterprise as an interest in real property that exists for the purpose of generating rents. This may be an interest in multiple properties. However, residential and commercial real estate must be considered separate enterprises. You can treat each of your rental properties individually or as a group. They may fall into any of the following categories:
- Residential real estate enterprise
- Commercial real estate enterprise
- Triple net lease real estate
A grouping rule applies to the safe harbor. Individual filers or pass-through entities must treat each rental property as its own separate enterprise. Alternatively, all similar properties (either residential or commercial, for example) must be grouped together and treated as a single enterprise.
As an example, assume that you have 10 separate properties. Eight of them are residential rentals. Two are commercial rentals. Under the grouping rule, you actually have two enterprises—one for residential rentals and the other for commercial rentals.
What are the requirements for the safe harbor?
Before considering how the safe harbor rules might affect you, you must determine if you qualify for it or not. Individual filers and pass-through entities must meet the following eligibility criteria:
- At least 250 hours of “rental services” are performed during the tax year.
- Separate books and records are maintained to detail the income and expenses of each rental real estate enterprise (if using the grouping rule, then maintain separate books and records for commercial and residential real estate).
- Contemporaneous records must be maintained (including logs, time reports, and similar documents) to specify the following details: 1.) Hours of all services performed 2.) Descriptions of all services performed 3.) Dates on which the services were performed, and 4.) Who performed the services.
Note that the contemporaneous records rule does not apply to any tax years prior to January 1, 2019. Of course, you will still need to verify everything before that date with records.
What are some examples of “rental services?”
Under the safe harbor rule, you must perform 250 hours or more of rental services during that tax year. This begs the question: What counts as a rental service? First, know that rental services may be performed by you directly, or by your employees, agents, or independent contractors. In other words, if you contract with a rental property management company, the services they perform on your property would qualify. Here are some examples of qualifying rental services:
- Advertisements for the rental or leasing of the properties
- The negotiation or execution of leases
- Verification of information found in prospective tenant applications (e.g. background checks)
- Collection of rent
- The operation, maintenance, and repair of rental properties
- Management of real estate
- Purchase of needed materials
- Supervision of employees and/or independent contractors
There are a few exceptions to be aware of. Qualifying rental services do not include the following:
- Commute (hours spent traveling to or from the rental properties)
- Long-term capital improvements (any planning, managing, or constructing activities)
- Financial or investment management activities (including procuring property, securing financing for said property, reviewing financial statements, or evaluating reports on operations
How can I make all of these requirements easier?
Tracking time spent on rental activities can be a headache for property owners and managers. However, it’s also the key toward the safe harbor. By tracking your time carefully and in a verifiable manner, it will be less of a hassle to prove that you qualify for the safe harbor.
I have triple net lease real estate. How can I qualify for the safe harbor?
Unfortunately, triple net lease real estate does not qualify under the new safe harbor rule. Remember, however, that the safe harbor rule is not the only way you can get your real estate to qualify for the Section 199A tax deduction. Talk to a CPA to find out how you can use the other method.
What about vacation homes?
You cannot use the safe harbor on any real estate that you use as a residence. Under Section 280A, your vacation home is either a residence or a rental property.
The Royce CPA Firm works closely with individuals and businesses to help them minimize liabilities and maximize deductions. If you have questions about the safe harbor or other implications of the new tax reform regulations, you can easily schedule an appointment online today.