The Internal Revenue Code (“IRC”) Section 199A Qualified Business Income Deduction (“QBI Deduction”) generally provides a 20% deduction (or reduction) of a taxpayer’s qualified net business income received from a pass-through entity’s (a partnership, S corporation, or sole proprietorship) operation of a qualified trade or business. Sands Anderson previously discussed tax reform and the QBI Deduction in “Conversations with Sands Anderson”.
To shed a little light on how the QBI Deduction works, here is a very basic example:
- Susan (married, jointly filing) is a 50% partner in a partnership called Widget Partnership from which she is allocated $300,000 of net taxable income annually. Susan is also an employee of a restaurant making $10,000 of W-2 income annually. Assuming Susan’s Widget Partnership income is eligible for the full QBI Deduction, her net taxable income for the year would be $250,000 ($10,000 of W-2 income and $240,000 from Widget Partnership ($300,000 – (20% of $300,000= $60,000 QBI Deduction)).
- This is a taxable income savings for Susan of $60,000 compared to if the QBI Deduction did not apply.
- With the QBI Deduction applied, Susan is taxed on her net taxable income of $250,000.
This is a greatly simplified analysis but paints a picture of how the QBI Deduction can create opportunities for tax savings.
On January 18, 2019, the Internal Revenue Service (“IRS”) provided much needed guidance regarding the new QBI Deduction. The guidance included:
- Final regulations for IRC Section 199A,
- New proposed regulations for IRC Section 199A,
- Revenue Procedure 2019-11 providing guidance on determining W-2 wages for the purposes of qualified business income for the purposes of IRC Section 199A, and
- Notice 2019-7 providing a proposed revenue procedure containing the safe harbor for the determination of whether a real estate enterprise is a trade or business for IRC Section 199A.
Notice 2019-7’s Proposed Revenue Procedure (“Proposed Rev. Proc.”) applies to taxpayers with taxable years ending after December 31, 2017. The Proposed Rev. Proc. can be used by taxpayers until the Proposed Rev. Proc. is published in final form.
The purpose of the Proposed Rev. Proc. is to provide a safe harbor for the determination of whether a real estate enterprise is a trade or business. The Proposed Rev. Proc. by its own terms specifically limits its applicability to the determination of trade or business status for the purposes of only IRC Section 199A. The requirements for the safe harbor could be met relatively easily and clear up taxpayer uncertainty. A failure to satisfy the safe harbor requirements does not preclude a taxpayer from otherwise establishing that a rental real estate enterprise is a trade or business.
The Proposed Rev. Proc.’s safe harbor is that a rental real estate enterprise will be treated as a trade or business if the following requirements are satisfied during the taxable year:
1. Separate Records
Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise;
2. Rental Service Hours
(a) For taxable years beginning prior to January 1, 2023, 250 or more hours of rental services are performed per year with respect to the rental real estate enterprise, or
(b) For taxable years beginning after December 31, 2022, in any three of the five consecutive taxable years that end with the taxable year (or in each year for an enterprise held for less than five years), 250 or more hours of rental services are performed per year with respect to the rental real estate enterprise; and
3. Contemporaneous Records
The taxpayer maintains 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. Such records are to be made available for inspection at the request of the IRS. The contemporaneous records requirement will not apply to taxable years beginning prior to January 1, 2019.
Rental services for the Proposed Rev. Proc. include:
- Advertising to rent or lease the real estate;
- Negotiating and executing leases;
- Verifying information contained in prospective tenant applications;
- Collection of rent;
- Daily operation, maintenance, and repair of the property;
- Management of the real estate;
- Purchase of materials; and
- Supervision of employees and independent contractors.
The Proposed Rev. Proc. allows rental services to be performed by owners or by employees, agents, and/or independent contractors of the owners. Allowing the activities of the enumerated agents of the owner will likely make the Rental Service Hour requirement easy to meet for many rental real estate enterprises. The drawback for many taxpayers will likely be the additional record keeping requirements of the safe harbor.
Definition of Rental Real Estate Enterprise
The Proposed Rev. Proc. defines a rental real estate enterprise as an interest in real property held for the production of rents and may consist of an interest in multiple properties. The individual or relevant passthrough entity (“RPE”) (as defined by Treasury Regulation § 1.199A-1(b)(10)) relying on the Proposed Rev. Proc. must hold the interest directly or through a disregarded entity.
The taxpayer must make a choice on how to characterize the rental real estate enterprise when the taxpayer owns multiple rental properties. The taxpayer can either treat each property held for the production of rents as a separate enterprise or treat all similar properties held for the production of rents grouped as a single enterprise. The IRS does restrict the grouping of rental properties by separating commercial and residential real estate into separate enterprises. Once the grouping decision has been made, the taxpayer cannot vary its treatment from year-to-year unless there has been a significant change in facts and circumstances.
Exclusions from the Safe Harbor
The Proposed Rev. Proc. has two types of exclusions:
1. Excluded Activities: Financial or investment management activities are excluded from counting towards the Rental Service Hours requirement. Financial or investment management activities include:
- Arranging financing;
- Procuring property;
- Studying and reviewing financial statements or reports on operations;
- Planning, managing, or constructing long-term capital improvements; or
- Hours spent traveling to and from the real estate.
2. Excluded Real Estate Arrangements: The following real estate arrangements are excluded from the safe harbor and cannot be grouped with qualifying real estate arrangements by the taxpayer when it characterizes the real estate enterprise:
- Real estate used by the taxpayer (including an owner or beneficiary of a RPE) as a residence for any part of the year under Section 280A; or
- Real estate rented or leased under a triple net lease.
The Proposed Rev. Proc. includes as a triple net lease, a lease agreement that requires the lessee or tenant to pay (or pay a portion of) taxes, fees, and insurance, and to be responsible for maintenance activities for a property (or maintenance activities allocable to the portion of the rented property) in addition to rent and utilities. Landlords may look to renegotiate their lease agreements to increase the rent along with the landlord’s responsibilities and services to attempt to qualify for the safe harbor.
Tax Return Statement
If you plan to rely on the safe harbor in Proposed Rev. Proc., then the Proposed Rev. Proc. requires that a signed statement be attached to the income tax return. Although the language in the Proposed Rev. Proc. is slightly ambiguous, the Proposed Rev. Proc. appears to require the statement to be on the tax return for the taxpayer who is first in the chain of ownership of the rental real estate enterprise who directly (or indirectly through a disregarded entity) owns the real estate enterprise. The requirement for a tax return statement would apply for the 2018 income tax returns whose filing deadlines are close at hand in spring 2019.
If you have questions or needs regarding the Proposed Revenue Procedure or tax reform, please contact one of the attorneys in our Tax Practice. We would be happy to assist with determining whether any potential opportunities exist for you or your business.
Disclaimer: This summary provided above is for general informational purposes only, and is not the provision of accounting, business, financial, investment, legal, tax, or other professional advice or services. This summary is not intended to substitute for the individualized professional advice for your particular business or personal circumstances. Please consult your professional advisors before making any decisions that may affect your business or individual finances. Sands Anderson PC shall not be responsible for any loss incurred by any person who relies on this summary.