By Greg Freyman
This tax blog specifically deals with how the new tax law affects the rental of real estate as an activity.
On January 18, 2019, the IRS released the final regulations for section 199A via Notice 2019-7.
If you have not heard of section 199A by now, you most certainly will very soon. This new addition to the tax law will be around until December 31, 2025.
How do the final regulations differentiate from the original legislation released in late December 2017?
If you recall we released a tax blog late December 2017 when the news first hit the presses. Here are the links to our summaries as it pertained to the business and individual tax law developments.
Overall, we have learned that most of the original regulation went unchanged as far as who will qualify for the tax deduction, but as many have said, it is analogous of a term paper writing crammed into one night. The IRS does, however, deserve credit for working on everything as fast as it did.
For an excellent summary on the overall final code as it pertains to its entirety, we would highly recommend the following reading in Forbes by Tony Nitti.
Are all taxes alike? If I do qualify for the section 199A deduction, what type of taxes will I be able to avoid?
Excellent question, the section 199A is a deduction specifically designed to reduce the federal income tax. The following list gives a few common tax types that are not going to be reduced with the section 199A deduction:
– Self-employment tax
– Net investment income tax
– Alternative minimum tax
I hear a lot of talk about the new section 199A deduction – am I eligible to claim the new section 199A deduction?
This is a great question, and as with all tax questions, the answer will be it depends.
There are many ways this deduction can play out in terms of actual practical application and in most cases, one can flat out receive a 20% deduction from their respective trade or business income for federal income tax purposes, and it will be very simple.
Then there is the rest.
Caveat Emptor (buyer beware) – to attempt to navigate maze on your own would not be advisable and always, and I stress the word “always”, consult with your tax professional first.
Why do you think it is so hard to determine if I qualify for the deduction?
There are many factors and limitations that may apply in order to assess if you qualify for a full/partial/or no section 199A deduction.
Here is a list of some assessments to make first to determine if you qualify for a full/partial/or no deduction:
- What is considered trade or business income?
- What is considered a specified service trade industry (SSTI)?
- Financial services
- How other qualified business income (loss) affects your total qualified business income or loss
- Activity grouping for certain activities
- How much in wages is your business paying
- How much qualified property does your business have
- Inflation index adjustments
- What is your filing status
- What is your personal taxable income
- Special business allocation for partners and shareholders
These examples should be enough to give you an idea of the complications at hand.
What about penalties for miscalculating?
Glad you asked, as many may think that penalties are simple, when in fact they are not at all simple, and just like with Baskin Robbins ice cream, penalties also come in many different flavors.
And just like with the ice cream, they sprinkle interest on top of all the penalties to add some flavor.
Common type of penalties:
- Late filing
- Late payment
Did you just list accuracy?
Yes, accuracy matters, and accuracy related penalties are quite hefty ones may I add.
Accuracy related penalties – SPECIAL RULE FOR TAXPAYERS CLAIMING SECTION 199A DEDUCTION
Internal Revenue subsection 6662 has a special place for accuracy related penalties, and the subparagraph (A) lists out the penalty amount at 5%.
The special rule for those clients that will be claiming the new section 199A deduction states that:
— In the case of any taxpayer who claims the deduction allowed under section 199A for the taxable year, subparagraph (A) shall be applied by substituting ‘5%’ for ‘10%’. —
They upped the ante! Let’s dive in a bit and dig a little deeper.
What if I made a mistake on my return, can I still amend my return?
Yes, you can do so in a case you rushed to file and did not do it properly.
Main Focus of This Newsletter – Rental Real Estate and The New Tax Law: Final Regulations 2019 – What you need to know ASAP
The focus of the article will deal with the status of trade or business as it pertains to the rental of real estate.
Key: In order to qualify for the qualified business income deduction under section 199A for rental real estate, we need for the rental activity to rise to the level of a trade or business as it is defined under section 162 of the code.
What is so complicated about defining trade or business?
You may think that because you consider yourself “in business”, you automatically are deemed to be conducting a trade or business. Unfortunately, the reality is very far from being this straight forward, after all, this is US taxation we are referring to.
Neither section 199A nor legislative history define trade or business
The final section 199A regulations simply circle back to define trade or business to section 162, which includes trade or business other than the trade or business of performing services as an employee – vague to say the least!
Note: The Treasury and the IRS failed to provide more specific guidance.
The good news is that you should not worry yourself and simply know that the vast majority in business are considered trade or business, however, when dealing with real estate activity, it is not as straight forward as a regular business, and this is because real estate can be held in multiple ways, as in the following examples:
- Personal residence
Why is it important for my rental real estate activity to be considered a trade or business for tax purposes?
Because the taxation will change for the activity in question, and you may avoid additional taxes, for example the Net Investment Income Tax (if ALSO the material participation tests are met), and you may qualify for tax deductions, for example the new Qualified Business Income Deduction.
That is correct, by checking the box as “trade or business” as is defined in code section 162, your rental property would have completely changed around the outcome of your income tax filing and hence, the ultimate accuracy of total taxes due (recall accuracy related penalties).
How do I know if my rental real estate activity qualifies to rise to the level of trade or business?
Since the tax law does not completely define the term, “trade or business” for rental activities, we have defaulted to looking at the amount of involvement in any one activity as described in tax code section 162. Under that section, the taxpayer must be involved in the activity “with continuity and regularity”.
If the rental property does not rise to the level of trade or business, it may default to an investment property (assuming it is not used for personal living and is not used for inventory (i.e. as in flipping properties) etc.) The contrasts between trade or business vs. investment property status are important as there would be a change in taxation – see our related article found here.
The distinction between trade or business and material participation
The trade or business test looks at the amount of involvement by the taxpayer and the taxpayer’s agents.
For example: Mr. Landlord spends about 30 hours a year managing a residential building. By hiring managing agents to perform the work, the taxpayer rose to the level of trade or business.
The key to understanding material participation and why it is much harder to meet vs. trade or business participation, is because material participation looks at the participation of the owner as an individual and the work performed by the agents is a negative.
Investopedia defines material participation for us with seven material participation tests.
For any tax year, a taxpayer, or their spouse, qualifies as materially participating in a venture if they satisfy any one of the seven material participation tests.
Test 1: participation for more than 500 hours.
Test 2: activity that constituted all participation substantially.
Test 3: involvement for more than 100 hours and not less than the participation of any other individual.
Test 4: which is a significant participation activity, combined with all significant participation activities, for more than 500 hours. A significant participation activity is a business in which the taxpayer participates, without qualifying for any of the other six tests, for more than 100 hours.
Test 5: participation during any five (5) of the preceding ten (10) taxable years.
Test 6: which is a personal service activity, for any three (3) prior taxable years. Personal service activities are activities in which capital is not a material income-producing factor such as health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting.
Test 7: partaking for more than 100 hours and based on all of facts and circumstances, on a regular, continuous, and substantial basis.
Now that we understand the difference between the two, I would like to briefly mention that in order to bypass the net investment income tax (NIIT), for example, you need to meet both tests.
As mentioned before in order to qualify for the qualified business deduction, the rental activity needs to rise to the level of trade or business, and since the level of involvement can vary greatly on a case by case basis, enter the new safe-harbor method under section 199A.
If the safe-harbor rules are met, the rental real estate activity will be considered as risen to “trade or business” level for the purposes of claiming the section 199A deduction.
In order to meet the safe-harbor the taxpayer must do the following:
- Rental Real Estate Enterprise activity
- Maintain special records and documentation
- Spend a certain amount of time on the activity
- Perform specific services
Captain’s log, star date, just kidding, not that type of Enterprise, see here ->
Defining Rental Real Estate Enterprise (RREE)
- An interest in real property that is held for production of rental income
- Does not need to be a single property and may in fact be multiple properties
- Interest can be held by an individual owner or via a separate legal entity i.e. partnership or single member LLC (disregarded entity)
- The taxpayer must treat each piece of real property as a separate enterprise or treat all properties similar in nature as one single separate enterprise
- If interest is held in commercial and residential properties together, that cannot be considered as one single real estate enterprise
- Once treatment is elected, it may not be modified every year, unless there is some sort of substantial modification that has transpired to the nature of the rental activity
It is important to note that the safe harbor can be elected to encompass the entire enterprise, in English, if you hold interest in 7 different properties, it is much harder to prove that you participate enough in each activity on an individual basis, and what is basically done is to combine the entire activity into one aggregation and to allocate your test to the entire lot as one single activity.
Does RREE include every type of rental real estate dealing?
No, here are the general exceptions:
- Residential real estate that is also used by the taxpayer as a personal residence over 14 days a year
- With minor exceptions, a triple net lease rental agreement
A triple-net lease: A lease in which the tenant is responsible for taxes, insurance, and repairs. For tax purposes is normally a mere investment.
Safe Harbor Requirements – Time Spent and Records kept
- Books and records are kept separately for the rental activity (or for the combined enterprise if aggregated)
- Before the commencement of tax year 2023 you must have 250 or more documented hours of rental services completed per year for the activity on an individual or aggregated basis
- Before the commencement of tax year 2023 you must have 250 hours of rental services completed in any 3 of the 5 consecutive years that end with that year – or – 250 or more hours in each year for a rental real estate enterprise held for an amount of less than 5 years on an individual or aggregated basis
Note: that the safe harbor can be elected on the entity level, and not only on an individual level. Also note that it IS possible to fail the safe-harbor, and that would NOT preclude you from meeting the trade or business activity guidelines. In case of an audit, though, it is much easier on the taxpayer who has met the safe-harbor test than it is to use the “facts and circumstances” to prove that their rental activity rises to the trade or business status.
Is that all that is needed to complete the safe-harbor requirements? no, take a close look at the words “documented” up above.
Safe Harbor Requirements – Documentation Requirements
The taxpayer shall keep contemporaneous records, which will include but will not be limited to the following:
- Time reports
- Similar documents reflecting the amount of time and involvement in the activity
What should the documents show?
- Hours of all services performed
- A detailed description of all services performed for the activity in question
- Service performed time/date
- Who specifically performed what services
Tip: you can acquire an app or keep record of what you do each day. A simple few notes on your calendar would work also, just save your work somewhere safe so you can pull it up at a future time in case you need to.
Safe Harbor Requirements – Specific Services Performed
In order to meet the 250-hour services requirement regarding rental real estate services, such services shall include the following:
- Advertising for the rental or lease of the property
- Negotiation and execution of lease agreements
- The verification of information inclusive in the prospective lease applications
- The actual collection of rent
- On-going management of operations, inspection, maintenance visits, repairs, evictions and so on
- The purchasing of materials to be utilized in any improvement or repair projects
- Employee/contractor management and oversight
Note: These services can be completed by the owner’s hired professional assistants such as a real estate agent, a building contractor, or hired employee personnel, and counted towards the owner’s time allotment.
What are some examples of what is excluded from rental services?
- Finance and investment activities for management of the activity
- The purchasing of the property
- Review of financial statements
- The management of capital improvements and other long-term construction or other projects
- Time spent traveling to and from the rental property
Separation of Trades
What if I run a bagel shop, a car wash, and regular real estate rental all under one LLC entity? Can I aggregate the three as one enterprise?
The notice says no, each one would have to meet its own definition of trade or business, even if the activity is housed in one entity.
Procedural Requirements – IMPORTANT!
The taxpayer MUST indicate on a statement attached to the tax filing and attest under the penalties of perjury that the safe harbor requirements have been fully met.
Aggregation of Activities for Section 199.A-4
Since it may be difficult to rise to the level of trade or business when multiple properties are involved in meeting the tests on an individual basis for RREE, we can aggregate our activity as one trade or business. It is important to note (although beyond the scope of this tax blog) that there are two types of aggregations, one is to meet the trade or business status and one is simply for computational purposes to maximize the deduction. Overall, and in general, aggregation is recommended in most cases.
Tax Return and Required Disclosures for Aggregation:
Each year, a statement must be attached to the tax return with information disclosing and identifying specific information about the business.
Also, for those that have been in the real estate game long enough and understand a bit more. Section 199.A-4 is not the same as grouping under section 469 of the code, although quite similar. Section 469 allows a taxpayer to group all activities into one and make the activities as if one economic unit or one interest exists. This was done to also meet certain tax tests and to make the most of the tax system in the past.
It’s advisable to speak with your tax professional before initiating these strategies. Contact our office at 904-330-1200 or email us at [email protected] to discuss these strategies, or if you have any questions.