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

Your Refund is Not Your Tax Liability

Piece of paper that says "TAX" with hand holding pen
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The Internal Revenue Service reports that so far this tax filing season, refunds are 9% down from last year. Reasons for this vary, but much of the change is attributed to the new tax law. Tax withholdings for federal taxes were reduced overall back in February 2018. If you didn’t do a “Paycheck Checkup” to compare your withholdings with your projected tax liability, the bottom line on your 2018 tax return could be a lot different than in the past.

Many taxpayers focus on whether they get a refund or owe more in taxes when it’s time to file. However, that is not the best indicator of your actual tax liability. Depending on a big refund to pay off bills or take a vacation also might not be the best way to manage your finances.

Think about it. Getting a tax refund means that you let the government use your money all year long before letting you have it. In other words, a refund is an interest-free loan to Uncle Sam. Does your bank lend you money for free? No! So why should you loan money to anyone – least of all the government – for free?

So how do you avoid making an interest-free loan or having to pay a lot at tax time? You’ve got to do two things – calculate your tax liability and withholdings, and compare the two amounts. Here are some tools to help you do it:

  • The IRS Withholding Calculator https://www.irs.gov/individuals/irs-withholding-calculator guides you through the steps to figure out your tax liability for 2019. Before using the calculator, make sure you understand how the IRS defines its terminology, know your pay frequency and note any life or work changes that impact your taxes (e.g., marital status).
  • If you owed additional tax for 2018, you may have to pay estimated tax for 2019. Estimated payments should be made if you expect to owe at least $1,000 in tax for 2019, and if you expect your total withholdings and refundable credits to be less than the smaller of 90% of your 2019 tax liability or 100% of your 2018 tax liability. More details are at https://www.irs.gov/pub/irs-pdf/f1040es.pdf

Your refund is not an indicator of your tax liability. Potentially, it’s an interest-free loan to the government that prevents you from using your own money. Doing a “Paycheck Checkup” get control over your taxes for next year and avoid making an interest-free loan or having to pay a lot next tax filing season.

How Americans Spend their Tax Refunds

The numbers are huge! Just a few days before the tax deadline, almost 120 million tax returns had been filed. More than 70% of those tax returns resulted in refunds back to the taxpayers totaling almost $243.6 billion. The average refund check or direct deposit amount was $2,831, slightly larger than last tax season.

 

So how do American’s spend their tax refunds?

 

GOBankingRates, a financial information and resources website, recently polled American taxpayers about how they planned to spend their tax refunds. The results were encouraging for money folks who preach fiscal responsibility. Here’s the full article. It’s an interesting read.

 

Per the survey, the five top ways that Americans spend their tax refunds are:

 

  1. Put into Savings – Forty-three percent of the survey respondents said they will put their refunds into savings. The survey was not specific about the type of savings. Let’s hope that savings includes an emergency fund for immediate needs and retirement contributions to meet long term goals.

 

  1. Pay Off Debt – Thirty-six percent said they will use the money to pay off debt. If that’s your situation, too, start by paying debt with the highest interest rate, like a credit card balance. More debt to pay after your refund is all used? Shift the amount you were paying on the paid-off balance to the next largest debt to get it paid off more quickly.

 

  1. Pay Toward a Vacation – Ten percent set aside their refund to pay for a vacation. Seems like a nice reward for getting through the year and filing that tax return. If your vacation funding choices are limited to putting it on a credit card or waiting for your tax refund, the refund “wins” every time – unless you can pay the card balance off each month.

 

  1. Splurge on a Luxury Item – Six percent go out and buy themselves a gift, whatever their heart desires. The bigger the refund, the bigger the splurge – jewelry, car, latest “bright, shiny object”. Let’s hope that these folks feel okay doing this because they already saved an emergency fund and maximized their retirement contributions.

 

  1. Necessary Major Purchase – Five percent need to use their refund for a major necessary purchase, like a home repair or appliance. Waiting to buy something you really need can be stressful, or even unsafe. Setting aside funds for emergencies and maintaining good credit are two ways taxpayers can avoid waiting for major purchases.

 

What about getting no refund?  The GOBankingRates survey found that 36 percent of those polled this year didn’t expect to receive a tax refund. Why is that a smart move? Well, you’ll have to check back and read my next blog to find out.