At the end of 2019, the IRS issued updated guidance on a new rental real estate safe harbor rule which allows certain rental real estate to be considered an “enterprise” eligible for a Section 199a deduction.
What is Section 199a deduction?
Section 199a gives owners of pass-through business entities an extra deduction of up to 20% of their qualified business income. A pass-through entity can be a sole proprietor, a partner in a partnership, a real estate investor, or an S-corporation shareholder. Qualified business income is generally defined as a business’s net profit.
How does that benefit a taxpayer with rental income?
If you have a rental property that generates positive cash flow, that amount is added to your taxable income and is taxed at your ordinary income tax bracket rate. Under the new safe harbor rules, provided that you meet specific criteria, you can take a deduction of up to 20% of the rental profits for the purpose of offsetting taxable income.
How many properties do I need to own to be treated as a real estate enterprise?
You can own any number of properties—even if it’s only a single property—to potentially qualify as a real estate enterprise. However, the properties must be the same type, meaning that residential real estate and commercial real estate cannot be mingled. In the case of a taxpayer who owns both commercial and residential real estate, each type could potentially be classified as its own real estate enterprise.
What are the safe harbor requirements?
In order to qualify for the Section 199a deduction, all four qualifications must be met for each real estate enterprise:
- Separate books and records must be maintained for each rental real estate enterprise. When a real estate enterprise contains more than one property, this requirement may be satisfied if income and expense information statements for each property are maintained and then consolidated.
- 250 or more hours of rental services must be performed per year for each real estate enterprise.
- Contemporaneous records must be maintained that document hours, dates, and types of services performed as well as the person who performed the services.
- The taxpayer must attach an election statement to their return.
Safe harbor requirements must be met annually; it is possible to qualify as a real estate enterprise in one tax year and not in a subsequent year!
Clarifying the 250-hour requirement
Rental services that count toward satisfying the 250-hour requirement can be performed by owners, employees, agents, or independent contractors hired by the owner and include time spent on the following:
- Advertising to rent/lease the real estate
- Negotiating and executing leases
- Verifying information contained in prospective tenant applications
- Collection of rent
- Daily operation, payment of expenses, maintenance and repair of the property, including the purchase of materials and supplies
- Management of real estate
- Supervision of employees and independent contractors
The following activities do not count toward satisfying the 250-hour requirement:
- Arranging financing
- Procuring property
- Studying reports on operations
- Planning, managing, or construction of improvements
- Hours spent traveling to and from real estate
Real estate enterprises that have been in existence for less than 4 years must meet this requirement annually. If the real estate enterprise has operated for at least four years, the taxpayer must perform 250 or more hours of rental services in any three of the five consecutive tax years to fulfill the requirement.
Consult your tax professional
Because there are many nuances that could potentially apply to your individual situation, be sure to consult your tax professional for advice tailored specifically to you.