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

Real Estate Professionals and Taxes

Real estate professionals take a lot of training and pass a really tough exam to earn a license to conduct business. Buyers and sellers of real estate are depending on their knowledgeable agent or broker to locate properties, bring the parties together, and navigate transactions to the settlement table.

 

Unfortunately, all that training and exam-taking doesn’t cover the special IRS tax rules that real estate professionals need to know and understand. Real estate professionals who don’t know the rules could end up getting an unwelcome tax notice about underpaying or incorrect filing.

 

Real estate professionals can avoid tax headaches by knowing about and understanding these three areas:

 

  1. Business Type for Tax Purposes

Real estate professionals operate their business as a sole proprietorship, unless the she or he forms a partnership or incorporates. The IRS considers licensed real estate professional as statutory nonemployees and treated as self-employed. This is because substantially all payments for their services are directly related to sales or other output, rather than to the number of hours worked. Real estate services are often performed under a written service contract providing that they will not be treated as employees.

 

  1. Tax Responsibilities

Real estate professionals are individually responsible for filing and paying all taxes, including federal, state, and local income, as applicable. Business income and expenses are reported on Schedule C, “Profit or Loss from Business,” and filed with the individual income tax return. Net business profits are also subject to the employer and employee portions of the Medicare and Social Security taxes (i.e., FICA), totaling 15.3% of net profit. FICA is paid to the IRS with the individual business owner’s income tax return.

 

  1. Deduction for Business Expenses

Expenses incurred to run a business as a sole proprietorship are deductible. The IRS does not publish an exhaustive list of eligible business deductions. The rules state that the business can deduct expenses that are “reasonable and customary” for that business. Common deductible expenses for real estate professionals include marketing, education, business licenses, and payroll taxes. Keep track of business expenses throughout the year; they really add up and reduce your taxable income.

 

Special IRS tax rules that real estate professionals need to know and understand aren’t included in the licensing test materials. Don’t know the rules? Consult www.irs.gov or with a qualified tax professional. You’ll be very glad that you did.