In a classic case of “the gift that keeps on giving,” the new IRC Section 199A included in the sweeping changes to the Internal Revenue Code introduced in the Tax Cuts and Jobs Act enacted by Congress in December 2017 has the potential to help certain business owners significantly reduce their annual tax bill with a 20% deduction against their “qualified” pass-through business income. With the caveat that when it comes to real estate, the new Qualified Business Income (QBI) deduction only applies against business income, and not against “mere” investments in real estate.
In other words, to qualify for the 20% QBI deduction as a rental real estate owner, a taxpayer must establish that they’re engaged in a “qualified trade or business” in the first place. Which, when it comes to rental real estate activity, isn’t always clear (especially since Congress didn’t fully define what constitutes “a business” for the purposes of the new IRC Section 199A in the first place)!
Fortunately for some, at the same time the IRS issues it’s first round of IRC Section 199A Final Regulations, it also released IRS Notice 2019-07, which provides a safe harbor for when a rental real estate enterprise will qualify as a business for purposes of the Section 199A deduction. Specifically, to qualify for the 20% QBI deduction on rental real estate, the taxpayer’s real estate must be directly owned by an individual or eligible pass-through entity (or through a disregarded entity), and their must also be at least 250 hours of total documented “rental services” activity performed in order to qualify.
Notably, though, this 250+ hour requirement carries its own quirks and nuances. Importantly, it’s not an overall requirement, but rather, the 250 hours of “rental services” must be performed for each enterprise, which again, potentially forces the taxpayer to make some important tradeoffs, since treating individual rental properties as separate enterprises has typically offered more flexibility for planning purposes but will now make it harder to qualify each separate property for the QBI deduction. Still, for purposes of counting those 250 hours, the IRS doesn’t require that the services (including such things as advertising, collection of rent, supervision of employees, operation and maintenance, etc.) be performed by the owner themselves, but instead can be performed by an agent, employee, or independent contractor.
Ultimately, individuals who don’t meet those safe harbor requirements still have the opportunity to “prove” that they have such a business (but they will bear the burden of backing up their claim (possibly in court) should the IRS stop in for a visit). Though shifting all rental activities to the lessor – e.g., via a triple-net lease – will unequivocally not qualify for the QBI deduction in the future, as it transitions the real estate purely into a passive investment holding!
Fortunately, for at least some rental real estate business owners, the safe harbor in the IRS Notice 2019-07 provides reasonable clarity about whether their rental enterprise(s) will qualify as a business. But significant complexity remains for some, especially those who own multiple rental real estate properties, and must make decisions that weigh maintaining them as separate enterprises, against the new burdens of ‘proving’ it is a rental real estate business without being able to meet the 250-hours-per-enterprise requirement.