When Rental Real Estate Qualifies as a Business

Cartoon picture of someone holding a white sign with dollars and coins.

The Tax Cuts and Jobs Act (TCJA) was signed and enacted in December 2017. In September 2019, almost two years later, the IRS issued final guidelines about whether taxpayers who rent real estate qualify for a new deduction under TCJA, the Qualified Business Income Deduction, aka “Code Section 199A”.  Section 199A allows business owners to deduct 20% of net business income on her or his individual income tax return. 

This new deduction is a very attractive tax benefit for eligible taxpayers. Who is eligible? TCJA extended the benefit to the owners of rental real estate but did not make clear what properties qualify and how to substantiate rental activities. Taxpayers and tax professionals had to use their best judgement to file 2018 income tax returns. Good news – guidance released last month clarifies when rental real estate is treated as a trade or business and how to substantiate the 199A deduction.

The September 2019 IRS guidelines state that rental real estate will be treated as a trade or business if the following requirements are satisfied during the tax year:

  • Maintain separate books and records of income and expenses for each rental property. You’ve already been doing that all along, right?
  • Perform 250 or more hours of rental services on rental activities. Good news – taxpayers with more than one rental property combine all activities to meet the 250 hours (i.e., the hours requirement is NOT per property).  Activities include advertising to rent the real estate; negotiating and executing leases; and management, operation, maintenance, and repair of the property, even services performed by a contractor or employee.
  • Maintain contemporaneous records, including time reports, logs, or similar documentation of the description and hours of all services performed; dates when such services were performed; and who performed the services (i.e., a contractor). Records could be requested by the IRS to substantiate rental activities.

As usual, the IRS guidelines address exclusions from Section 199A eligibility, including:

  1. Travel to and from the rental property does not count towards the 250 hours of rental services. 
  2. Real estate used by the taxpayer as a residence for any part of the year is not eligible.
  3. Real estate rented under a triple net lease is also not eligible, although the activity may qualify as a trade or business, depending on the owner’s business activities. 

There’s more! Starting with 2019 individual income tax returns, taxpayers with activities that qualify for the Section 199A deduction must include a statement indicating that the 199A deduction is being claimed using a new form, Form 8995, Qualified Business Income Deduction

Want more details? The IRS website has them here https://www.irs.gov/newsroom/irs-finalizes-safe-harbor-to-allow-rental-real-estate-to-qualify-as-a-business-for-qualified-business-income-deduction

Want Clarity? Put Agreements in Writing!

Small businesses and nonprofits sometimes need a professional with specialized skills to help them out, like a human resources or financial consultant. Most organizations need to purchase materials or inventory items. Getting services or goods from a third party, or outsourcing, can add significant value to an organization, as long as it’s managed right. Outsourcing management starts with a clear, written agreement that both parties understand and follow.

A written agreement should address key components of both parties – the vendor’s responsibilities, as well as the organization’s. These four components should be addressed in all vendor agreements to clarify expectations and hold all parties accountable:

Objective and Scope

Clearly describe the results or accomplishments that the vendor should achieve on the organization’s behalf, as well as any requirements for the organization. Specifically describe what the organization expects to get when the vendor’s work is completed. For example, an agreement for an IT vendor to install and maintain a new system would describe, among other things, the end state after the system is installed, performance requirements and any ongoing maintenance.

Time Frame and Frequency

Specify delivery dates and how often your organization needs the goods or services provided. Clarify any unusual needs you have, such as nights or weekends, to avoid misunderstandings   that will prevent the organization from meeting its customers’ expectations. How would it look if a 24/7 café couldn’t get fresh food delivered on a Sunday? Highlight timing and frequency to make sure the vendor knows when she or he is needed.

Delivery and Acceptance

Describe the expected condition, appearance, format, or other requirements that are essential for the goods or services to achieve the organization’s objective. Do the flyers need to be blue with your logo? Does the training class need to be two-hours long and meet specific learning objectives? Should goods be delivered in a certain way? Don’t presume that the vendor will understand all specific needs. Put them in writing.

Cost and Payment

Last, but certainly not least, be clear about the vendor’s total cost and when payment will be made. Specify what is included in the total cost and how that cost is calculated. For example, is the cost for paper per box or per carton? Does the consultant cost an hourly rate plus expenses, or will she or he absorb those expenses? Hold vendors accountable by stipulating that payment will only be made after goods or services have been accepted, or when a specified objective is met.

All organizations need help with professional services or purchase from an outside source. That help can be great, but not if it doesn’t meet the organization’s needs. Having a written agreement that clarifies expectations and holds all parties accountable is the best way for organizations to successfully manage outsourced needs.

Year End Reflections and Plans for 2019

Year end is the perfect time to reflect on and celebrate accomplishments made during 2018. Yes, year-end is time to enjoy your success. It’s also a great time to plan for the accomplishments you want to achieve in 2019. Whether you are expanding or launching something new, setting objectives is your starting point.

First, identify a few specific areas of your organization you’d like to change or improve in 2019. Want higher profits, cash flow or client base? Need a new employee or system? No change or improvement will happen without a plan to get it done, starting with clear and detailed objectives.

Follow these three tips for objectives that give you a head start toward the finish line:

Gather the Numbers

Quantify all the applicable aspects of your objective. This task will require some research

and could entail making estimates and assumptions. For example, how much profit or client growth do you want to achieve? Can you express that growth as a dollar amount and as a percentage? How much would a new system or employee cost? How much of that cost would be one-time and how much would be ongoing? The more numbers you can nail down or estimate, the better.

Be Realistic

Keep market conditions and your resource capacity in mind when setting growth objectives. It’s important to be realistic in order to ensure that your objectives are achievable. Setting unrealistic objectives is not only discouraging, it can result in allocating resources – aka time and money – on activities that are unlikely to succeed. Better to target those resources on realistic, achievable objectives.

Adjust As Needed

No matter how well you research, estimate and focus on the achievable, any view of future events is imperfect. Market conditions and other factors that you depended on when setting your objectives could change. Periodically assess progress on meeting your objectives. Are you on track? Why or why not? Based on those answers, you may need to make some adjustments to the objectives that you set at the beginning of the year.

Year end is the perfect time to reflect on and celebrate the year’s accomplishments and to plan for the objectives you want to set for next year. Identify specific things you’d like to change, set detailed and clear objectives, and you’ll have a great head start to improve your organization in 2019.

When Does Your Business Need a CFO?

Bookkeeping is one of the first services that businesses outsource or hire for. Time running the business is too valuable to spend it recording transactions and running reports. A bookkeeper records your transactions, provides you with regular financial reports, etc., etc. All important tasks for running your day-to-day. Planning for growth or other long term business decisions requires analytical and management skills that focus on the broader view, not the day-to-day.

A Chief Financial Officer, or CFO, provides the analysis and financial direction that businesses need to get to the next level. Most small businesses can’t afford a fulltime CFO, but can afford to engage a CPA firm or financial consultant to perform the CFO role for a few hours a month. A part time CFO is a business investment in sustaining and growing your business.

Businesses need a CFO when:

  • Cash Flow Projections Aren’t Reliable

Knowing how much cash is available to run and invest in your business is crucial to keeping your doors open. Dire and expensive surprises happen to businesses that aren’t confident about their bank balances, revenues coming in, and payments going out. If monthly cash flow looks nothing like your cash projections, a CFO can establish a cash flow process that provides useful results based on reliable information.

  •  Budgeting is Ad Hoc or Doesn’t Happen

A budget articulates the financial resources needed to deliver your services or product, maintain your infrastructure, and invest in growth or improvements. It should be zero-based, or “built from scratch” to identify the cost of the resources needed for each budget category. For example, determine how many staff is needed to meet operational objectives and the “fully loaded” cost of each staff member. A CFO can help you build a budget that effectively addresses all applicable costs and revenues.

  • Prices Aren’t Covering Costs

Charging the same price as the competition might work for the other guy, but if it doesn’t cover your costs you won’t be in business for long. Pricing your service or product requires knowing your costs and understanding the value that distinguishes your business from that “other guy”. A CFO can examine your costs, identify the fixed, variable, direct and indirect cost components, and advise you on pricing and profit margins.

A CFO’s skill set and experience focus on the analysis, planning and management required to make higher-level financial decisions needed to get to the next level. Whether it’s growth, innovation, or sustainability, a CFO can provide insights and perspective to help achieve your financial and operational objectives. Getting a CFO is a business investment that pays you back over and over again, as your business launches to the next level.

2018 Tax Planning – The New Tax Law Will Impact Your Return

It’s summer! Know what that means? Time at the beach? Sure! Road trip? Absolutely! Summer camp? Well, almost… Summer Camp for Tax Professionals, aka the IRS Tax Forum, just happened here in Washington, DC. It’s perfectly timed between the April and October tax filing deadlines, with a chance to learn about tax trends, changes, and issues from the IRS and experienced tax professionals.

 

Timing was better than ever this year because of all the sessions on the Tax Cuts and Jobs Act that was passed in December 2017. The 2018 IRS Tax Forum provided details about how the new tax law will impact nearly every household and business in the nation. Tax professionals also got insight on new security and compliance procedures implemented by the IRS, state agencies and tax software vendors to reduce identity theft and fraud.

 

2018 IRS Tax Forum sessions covered a range of updates and issues, including:

 

  • Changes to employer tax withholding tables that do not consider the taxpayer’s specific situation. This could result in an expensive surprise next tax filing season.
  • New qualifying dependent credits and higher income limits for taking dependent and child tax credits. These credits partially offset elimination of personal exemptions.
  • Itemized deduction limits for state-level taxes and mortgage interest.
  • Elimination of moving and miscellaneous itemized deductions.
  • Clarification about eligibility for the new Qualified Business Income deduction for Sub S Corporations and Partnership clients (i.e., pass-through businesses).
  • New requirements for Sub S Corporations and Partnerships to track and report stock and loan basis.
  • Changes to depreciation and expensing rules for business assets.

 

There’s more. Too much for one blog post. Now is a great time for every taxpayer to check into how the new tax law will impact her or his tax bill for 2018. In a few months, it will be too late to make a change.

 

If you’re up for re-visiting your tax projections yourself, there’s plenty of online help. Guidance to project taxable income, tax withholding, deductions and tax liabilities is at the IRS website, https://www.irs.gov/individuals/irs-withholding-calculator for employees and https://www.irs.gov/businesses/small-businesses-self-employed/estimated-taxes for business owners.

 

Not sure you want to DIY your taxes? Want help figuring out how the Tax Cuts and Jobs Act will impact you? Get a referral for a qualified tax professional, preferably one who went to Summer Camp for Tax Professionals, aka the IRS Tax Forum.

Meal and Entertainment Deductions Under TCJA

Having a business meeting over a meal or celebrating a big contract with a team happy hour are common events. Before the 2017 Tax Cut and Jobs Act (TCJA), meals and entertainment directly related to a business activity were considered a “reasonable and customary” business deduction, subject to strict rules. For example, meals and entertainment that were considered “lavish” or where the taxpayer or her employee was not present were not tax deductible.

 

Passing the TCJA changed all of that. Or did it? Some confusion is still out there, leading to some people thinking that meals and entertainment expenses are no longer deductible. Not true! That misunderstanding could lead to missing some business deductions, and paying higher taxes. Not good!

 

In reality, the new tax law is so vague it does not specifically define the expense commonly known as a “business meal.” TCJA language retains the requirement that “the taxpayer or his agent” be present for the business meal to be deductible. However, it does not retain the “directly related” and “associated with” standards that used to apply.

 

The change in meals and entertainment language and how it will be interpreted by taxpayers and their tax advisors has not been tested. Recommended practice under TCJA is in line with common practice pre-TCJA. So what does that mean for you?

 

Under TCJA, businesses can deduct 50% of the cost of meals and entertainment when:

 

  1. The taxpayer or his agent is present and conducting business.

 

  1. Expenses are not lavish or extravagant under the circumstances.

 

  1. Records are kept of the date, amount, business purpose and attendees.

 

These “new” requirements look a lot like what most of us have been doing since 1986, the last time tax law changed related to business meals and entertainment. So don’t worry about taking a client out to a dinner meeting. Have a team meeting at the happy hour location, and then stay for some team bonding.  Keep the expenses reasonable, maintain complete records, and take that tax deduction. It’s okay.

Is Your Price “Right?”

The Price Is Right is a fun game show, but deciding the right price for your product or service is no game. Charging enough to make a profit and stay competitive in your market is a careful balancing act. You need to pay the bills without driving customers away from your business to the competition.

 

Figuring out Your Right Price boils down to three fundamentals:

 

  1. Cost – Start by identifying all of the costs associated with making your product or delivering your service. Not as easy as it sounds. The most obvious costs are usually the direct costs, like materials and labor. Rent, utilities and supplies are also easy to identify. Less obvious are costs that don’t happen all the time, like marketing and memberships. Add up all the costs to form a budget for the month or year to get a feel what it costs to deliver your product or service.

 

  1. Competition – Know your market, industry and competition to use as a benchmark, but not your only guide. Your competitors’ prices do not tell you if they are operating at a profit or anything else about the inside of the organization. Is there a lack of competition or unmet demand in your market? Competitive pricing under the right circumstances is a great opportunity to capture market share.

 

  1. Value – Identify and market the value proposition that differentiates your product or service, and use it to command a higher-than-average price in your market. Does your team have credentials, experience or knowledge that the competition doesn’t have? Do you offer a higher quality, longer lasting product? All of that can be reflected in a higher price.

 

Making sure that Your Price is Right is no game. Should you charge less to gain market share, or charge more to highlight your quality? Will you be able to cover your costs and make a profit? Feel confident that Your Price Is Right by considering the three fundamentals — cost, competition, and value.

Fraud and Workplace Culture

Last week’s blog was about the three types of fraud and how to prevent them. Typically, organizations lose 5 percent of revenue to fraud each year. Think about how much that means to your organization’s bottom line. Not pretty. Fraud hits smaller organizations and nonprofits even harder, which means a bigger bite out of annual revenue.

 

The Association of Certified Fraud Examiner’s 2018 Report to the Nation on Occupational Fraud and Abuse says that the median loss of fraud cases examined over the last two years was $130,000. Twenty-two percent of losses exceeded $1 million!

 

Organizations can be reluctant to report fraud to law enforcement for two related reasons – bad publicity and poor internal disciplines. Reputations and bottom lines are hurt when a fraud case is exposed in the headlines. It’s even worse when the story behind the headline reveals that financial controls and oversight were so lax, the organization essentially handed the stolen funds to the fraudster.

 

Financial controls that fail to detect or prevent fraud are the symptom of a larger issue – poor workplace culture. What is that, and why is it important? Workplace culture is the personality of an organization – the values, accepted behaviors and attitudes that make the environment and its people work together.

 

Part of a strong workplace culture is promoting ethical, honest and transparent actions, starting with senior management. A strong tone at the top goes a long way to letting everyone in the organization know that dishonest and unethical behavior is not tolerated. Fraud is less likely to occur in an organization with strong workplace culture and tone at the top.

 

So here’s the ironic part. In a recent report, The Culture Economy, 60% of smaller business leaders think that strong organizational culture is a “nice to have” thing, not a necessity. What?! Just look at the fraud statistics to see how essential workplace culture is to the financial success of an organization. Sure, not everyone working in a place with lax financial controls is going to commit fraud; but lax controls make it easy for the dishonest or financially-stressed employee to steal or engage in corrupt practices.

 

A strong workplace culture lets your employees know that fraud and other dishonest behavior will not be tolerated. Of course, strong financial controls and oversight are important. Clear messaging about expectations and appropriate actions go a long way to making sure your employees know that fraud will not be tolerated.