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How to Qualify Your Rental Activities for the 20% Business Income Deduction

This is Part 1 of a Two-Part series on applying the Qualified Business Income Deduction (QBID) rules to rental activities.

In this Part 1, we'll review the new IRS "safe-harbor" guidelines for determining whether your rental activities qualify for the QBID.

In Part 2, we'll discuss the practical implications of the safe-harbor guidelines and furnish advice on what to do the last several months of 2019.

One of the most popular provisions of the recent Tax Reform bill was the Qualified Business Income Deduction. In a nutshell, QBID allows the owner of a flow-through business to claim a deduction on their Personal income tax return for an amount equal to 20% of the income from the flow-through business.
 
As the Tax Reform bill was nearing passage in December 2017, a provision was added at the last minute to apply QBID to rental activities that "rise to the level of a trade or business."
 
This mysterious language has led to a lot of uncertainty and speculation among advisors and tax practitioners on how to apply the QBID rules to the rental activities of clients and taxpayers.
 
On one hand, owning a large office building employing property managers and maintenance workers would seemingly rise to the level of a trade or business. On the other hand, what about the taxpayer who owns a single rent house? Or two rent houses? Where do you draw the line?

The New IRS "Safe-Harbor" Guidelines for Rental Activities

In an attempt to provide clarity, the IRS issued safe-harbor guidelines earlier this year on applying the QBID rules to rental activities for 2019 and future years. For taxpayers who can satisfy the safe-harbor conditions, the profits from their rental activities will qualify for the 20% deduction. For taxpayers who cannot satisfy the safe-harbor guidelines, the IRS says other evidence can be provided to prove a trade or business, though we believe this will be a difficult burden to bear.
 
Here is a breakdown of the new guidance:
 
Rental Real Estate Enterprise (RREE)
 
The foundation for the safe-harbor guidance is based on the creation of a new, fictional business entity the IRS refers to as a Rental Real Estate Enterprise or RREE. A RREE will be deemed to hold one or more rental properties held directly by a taxpayer or a disregarded entity, such as a single-member LLC.
 
If a taxpayer holds more than one rental property, the taxpayer will need to make a one-time, irrevocable election to treat each property as a separate RREE or combine similar properties into a single RREE. As explained further down this article, we believe most taxpayers will want to combine multiple rental properties into a single RREE.
 
One of the curious aspects of the IRS guidance is the fact commercial and residential rental properties cannot be combined into a single RREE. The IRS has been silent on their rationale for this distinction.

The Three Elements of the Safe Harbor
Once you have determined the structure of your RREE(s), there are three elements of the Safe Harbor that need to be satisfied:
  1. Maintain separate books and records for each RREE. The IRS did not provide guidance of what would be acceptable in this regard. It might include a QuickBooks subscription, an Excel file or an annual recap of rents collected and expenses paid. One idea we suggest is to maintain a separate bank account for each RREE to facilitate an annual compilation of business activity. This may be one good reason for combining multiple rental properties into a single RREE.
  2. Devote 250 or more hours of rental services to the RREE. These services include advertising, verifying tenant applications, collecting rent, maintenance & repairs and many others. They do not, however, include services for buying property, arranging financing, commuting to the property or studying financial reports. One surprising aspect of the guidance is the 250 hours can be performed by third parties, such as a property management firm, a plumber or an attorney to draw up the lease. This 250-hour threshold may be a second good reason for combining multiple rental properties into a single RREE.
  3. Maintain contemporaneous time records to track hours and activities. As with the first element, the IRS did not mandate how to track hours and activities. Perhaps a daytimer, diary or Excel file will do the trick. The emphasis, though, is contemporaneous (which does not mean the evening before meeting with the IRS auditor). The time records need to indicate who did the work, when the work was done and how long it took. This is perhaps a third good reason for combining multiple rental properties into a single RREE.

Not All Rental Properties Are Eligible for the Safe Harbor
 
The IRS described three types of rental properties that are not eligible for Safe Harbor consideration:
  1. Property used as a Vacation Home (with partial rental use)
  2. Property used as an Office-in-the-Home
  3. Properties rented under a Triple Net Lease
The exclusion of triple net lease arrangements has us scratching our heads since this is a very common type of lease, particularly for commercial properties.
 
Even with these listed exclusions, the IRS did say taxpayers could furnish evidence to prove the existence of a trade or business.

Taxpayer Certification of Compliance
 
In what we consider to be the most troubling aspect of the IRS guidance is the requirement for each taxpayer claiming the benefits of the Safe Harbor to sign and attach a statement to their tax return saying they have met all three elements of the Safe Harbor.
 
First of all, the IRS did not furnish an example of the format or language to be used in the statement. Second, the statement has to be signed under penalties of perjury. This could potentially expose taxpayers to civil and even criminal sanctions if it is later determined compliance with the Safe Harbor was deficient.
 
About Part 2
 
We'll give you some time to digest these new rules and furnish Part 2 in a couple weeks. At that time, we'll review the practical implications for most taxpayers. In addition, we'll share our perspective on best practices and a process for implementing the Safe Harbor.
 
In the meantime, be sure to let us know your questions.


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