Final regulations shed some light on the QBI Deduction and rental real estate: A key provision of the new tax law is the Qualified Business Income Deduction (QBI Deduction), which is available to qualifying trades or businesses. The key phrase here is “trade or business”, which isn’t clear cut with regard to rental real estate.
The IRS released safe harbor provisions from which rental real estate may qualify as a trade or business and benefit from the deduction. However, one of the requirements is creating hesitancy among taxpayers to state under penalties of perjury that they meet all of the provisions of the safe harbor (250 hours of service with adequate documentation).
Here is a Safe Harbor provision that applies to rental real estate:
The provision requires that the owner or agents or contractors spend 250 or more hours of serviceon parcel or parcels of properties although residential and commercial real estate cannot be combined. The provision requires separate accounting records and that the taxpayer maintains contemporaneous records, including time logs or similar documents regarding the following:
- Hours of service performed
- Description of services performed
- Dates on which services were performed
- Who performed the services
The Safe Harbor provision is to be signed as part of the tax return “Under Penalties of Perjury”.
Penalties of perjury are monetary fines of not more than $1,000 or imprisonment of not more than one year or both.
The new tax law does have other penalties associated with the Qualified Business Income Deduction as it imposes a penalty for underpayment of income tax that exceed the greater of 10% of the correct amount of tax or $5,000 but if a taxpayer claims the QBI deduction the threshold is lowered to 5% or the correct amount of tax or $5,000. The penalty amount is 20% of the tax adjustment by the IRS.
Absent claiming the safe harbor provision for the rental, you can rely on the “trade or business activity” criteria, of which we are requesting your response to verify your rental qualifies.
To meet the standards of a trade or business activity under code section 162, the activity must be:
Relevant factors to include:
- The type of property rented (commercial or residential)
- The number of properties rented
- The owner or agent’s day-to-day involvement
- The types of ancillary services provided under the lease
- The terms of the lease
The following types of activities can be considered that satisfy the criteria of regular, continuous and considerable:
- Advertising to rent or lease
- Negotiating or executing a lease
- Verifying information on prospective tenant applications
- Daily operation, maintenance and repair of the property (do don include hours incurred for capital improvements)
- Purchasing materials
- Supervision of employees or contractors
The following types of activities do not help meet the trade or business activity as the activity is associated more closely with investment management:
- Arranging financing
- Purchasing a property
- Managing or construction of capital improvements to property
- Studying or reviewing financial statements
- Hours spent traveling to real estate
A person or reporting entity may group parcels of residential property together to meet the trade or business standard. They may also group parcels of commercial property together to meet the standard but the grouping of residential properties and commercial properties is not allowed.
Many taxpayers will be hesitant to sign the safe harbor provision due the penalty of perjury statement. However, the safe harbor provision does give us some insight on what the IRS deems as a minimum hour requirement to meet the standard of the trade or business associated with real estate. The safe harbor suggests that a minimum of 250 hours must be spent annually by owners, agents or contractors on the management and maintenance of the property. A person or reporting entity such as a partnership can group commercial properties to meet 250 hours or they can group the residential properties. There is no grouping of the commercial properties with the residential properties allowed to meet the 250 hours. In addition, there is no grouping of properties held from various reporting entities (a partnership will stand on its own). Unfortunately, we are unsure if the 250 hour requirement of the safe harbor is enough hours to satisfy the requirement as a trade or business but the safe harbor provision does give taxpayers an arguable position if a tax return is selected for audit by the IRS.