The new qualified business income deduction that was created as part of the Tax Cuts and Jobs Act can be a great tax-saving tool for some small business owners, but it is complex and carries several requirements before the deduction can be realized.
Using the qualified business income, or QBI, deduction under Section 199A, eligible taxpayers may be entitled to a deduction of up to 20 percent of QBI, a significant tax savings for owners of sole proprietorships, partnerships, LLCs, S corporations, trusts and estates.
The Section 199A deduction is a complicated deduction with many reporting and record-keeping obligations. It is so complex, in fact, that it has required numerous clarifications and proposed regulations since its passage in late 2017.
Most recently, the IRS issued new guidance regarding rental real estate enterprises. The QBI deduction is available for what Section 199A defines as a “qualified trade or business,” which is “any trade or business other than a specified service trade or business.”
There was some confusion over whether a rental real estate enterprise was considered a specified service trade or business like a law firm or accounting firm would be. (For more about what qualifies as a specified service trade or business, please see our Aug. 21, 2018, article on the topic.)
Under the most recent proposed procedure, individuals or entities who own rental real estate directly or through a pass-through entity can claim the QBI deduction as long as they or someone they hire spend at least 250 hours a year involved with the business.
To qualify for this safe harbor, a rental real estate enterprise is defined as an interest in real property held for the production of rents and may consist of an interest in multiple properties. It must satisfy these parameters:
- The individual or pass-through entity must hold the interest directly or through an entity separate from its owner;
- Taxpayers must treat each property held for the production of rents as a separate enterprise or treat all similar properties held for the production of rents as a single enterprise; and
- Commercial and residential real estate may not be part of the same enterprise.
According to the IRS, rental services that qualify for the QBI deduction include:
- Advertising to rent or lease the property;
- Negotiating and executing leases;
- Verifying information in a prospective tenant’s application;
- Rent collection;
- Daily operation, maintenance and repair of the property;
- Property management;
- Purchase of materials; and
- Supervision of employees and independent contractors.
Rental services for this purpose do not include financial or investment management activities, such as 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 rental property.
The IRS has also implemented some strict record-keeping requirements that will need to be met beginning as of Jan. 1, 2019, with respect to rental real estate enterprises. Those are:
- Separate books and records must be maintained reflecting income and expenses for each rental real estate enterprise;
- Proof that 250 or more hours or rental services are performed either by the owner or someone hired by the owner. Beginning Jan. 1, 2023, the 250 hour requirement must be shown in any three of the five consecutive taxable years;
- The taxpayer must maintain contemporaneous records, including time reports, logs or similar documents showing:
- Hours of all services performed;
- Description of all services performed;
- Dates on which such services were performed; and
- Who performed the services.
- A statement signed by the taxpayer or representative of the pass-through entity must be attached to the return on which the Section 199A deduction has been claimed.
It is hard to overstate the importance of keeping these documents. You must be prepared to make these records available at any time for inspection at the request of the IRS. For more about the reporting requirements involved with QBI, please see our Nov. 5, 2018, article.
In addition to these requirements, IRS has also clarified that real estate rented or leased under a triple net lease is not eligible for this safe harbor. In other words, any rent or lease agreement that requires the tenant or lessee to pay taxes, fees and insurance, and to be responsible for maintenance activities in addition to rent and utilities would be ineligible for the QBI deduction. This includes lease agreements where the tenant or lessee is required to pay a portion of the taxes, fees and insurance and to be responsible for maintenance activities allocable to the portion of the property rented by the tenant.
We believe the Section 199 QBI deduction can be very valuable and beneficial. At the same time, we know it is very complex and the Treasury Department is continuing to work on regulations that govern the QBI deduction. We will monitor these changes and keep you apprised as further information becomes available. Please contact us if you have any questions.
Tamra Newman, CPA, is a Tax Manager with Antares Group, Inc. She can be reached at firstname.lastname@example.org.