19 January 2019
I did not expect to be posting a blog article today, but much to my surprise, the IRS released a proposed Revenue Procedure late yesterday, and I felt like I needed to provide some information and guidance. (Treasury (the IRS) releases Revenue Procedures as formal guidance to taxpayers on how to apply the tax law.) The proposed Revenue Procedure is designed to clear up the confusion as to whether or not rental real estate qualifies for the new Section 199a “Qualified Business Income” deduction. I wasn’t surprised by the content of the proposed Revenue Procedure. I was surprised we received guidance before the tax season was officially underway! Clear guidance isn't nearly as abundant as I would like during normal times. With the government shutdown and big chunks of the IRS out on furlough I figured there was no way they could issue coherent and timely guidance. I was pleasantly surprised they gave us both. Let me break it down for you.
As part of the December 2017 tax reform - the Tax Cuts and Jobs Act (TCJA) - there is now a tax deduction written into the tax code known as the Section 199a deduction (cleverly named after the paragraph in the Internal Revenue Code that describes it.) You might also see it referred to as the Qualifying Business Income deduction or QBI deduction because it is a deduction on Qualifying Business Income (QBI). It’s complicated, but in a nutshell, qualifying pass through business can deduct 20% of their income, essentially making that 20% insulated from federal income taxes. It is a REALLY good deduction. Landlords want to be able to claim it, but questions lingered as to whether residential rental real estate was considered a 'qualifying business'.
After interim regulations came out in August, most tax pros believed holding out real property for the purpose of generating rents (a.k.a. being a landlord) would qualify for the Section 199a deduction. Count me among them. It seemed like that was Treasury’s intent, but there was still room to interpret the new law in different ways.
Yesterday’s release of the new proposed Revenue Procedure finally put that to rest.
What the Proposed Revenue Procedure Says
The proposed Revenue Procedure establishes a Safe Harbor for landlords looking to claim the Section 199a deduction. By establishing a Safe Harbor, the IRS is essentially saying, “If you have residential rental property and you comply with the following guidelines, then you will qualify for the Section 199a deduction.”
There are just 4 guidelines:
A) You must maintain separate books and records for your rental business.
(Paul’s interpretation: Do not run your real estate activities through your personal bank account. The Section 199a deduction is for BUSINESSES. You are expected to treat your real estate enterprise like a business in order to get this deduction.)
(B)(1) For tax years 2018 - 2022 you must work at least 250 hours per year on ‘rental services’. (I’ll explain rental services later.)
(B)(2) Beginning in 2023 you must work at least 250 hours per year for 3 of the previous 5 years on ‘rental services’. (I’m just trying to make it through January 2019, and they are giving me guidance on 2023 and beyond? Oy!)
(C) The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, regarding the following:
(1) hours of all services performed
(2) description of all services performed
(3) dates on which such services were performed
(4) who performed the services
(Paul’s interpretation: You need to clock in and clock out when you are working on your rental property business.)
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. (Paul’s interpretation: You don’t need these records for 2018.)
(D) You must attach a signed statement to your tax return indicating you are claiming the Section 199a deduction, and you are compliant with the proposed Revenue Procedure. It must also contain the following language: “Under penalties of perjury, I (we) declare that I (we) have examined the statement, and, to the best of my (our) knowledge and belief, the statement contains all the relevant facts relating to the revenue procedure, and such facts are true, correct, and complete.”
The proposed Revenue Procedure describes rental services as follows:
- 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
- supervision of employees and independent contractors
The proposed Revenue Procedure is also careful to specifically exclude the following activities from qualifying as rental services:
- arranging financing
- procuring property
- studying and reviewing financial statements or reports on operations
- planning, managing, or constructing long-term capital improvements
- hours spent traveling to and from the real estate
There was some additional guidance in the proposed Revenue Procedure about how to aggregate (or not aggregate) your properties for your business enterprise, as well as a prohibition on mixing residential and commercial properties in the same enterprise. Those are important to a few people, but I don’t want to get into that yet. For now I just want to make sure the majority of my landlords know there is concrete guidance on whether and how to claim the section 199a deduction.
The IRS was also quick to point out that you are not precluded from claiming the Section 199a deduction just because you don't qualify for the Safe Harbor. You may still qualify for the Section 199a deduction even if you violate the guidelines in the proposed Revenue Procedure. Your unique facts and circumstances would need to be analyzed when making that decision
Bottom Line: Separate books and bank accounts, start keeping records of your rental service activities, and enjoy your Section 199a deduction!
If you still have questions, ask! (757) 407-4189