Qualified Business Income Deduction – Final Regulations and Safe Harbor for Rental Property

On Friday January 18, 2019 the Treasury Department and the Internal Revenue Service issued final regulations and some additional information on implementing the new Qualified Business Income (QBI) deduction (also called the Section 199A deduction) for the current tax season. Last August, the Treasury Department released proposed regulations on the Section 199A deduction, but the final regulations released last Friday, along with the new proposed notice regarding real estate rental activities, offer greater guidance on how taxpayers can utilize this new QBI deduction.

The QBI deduction was created in the Tax Cuts and Jobs Act (TCJA) and it allows many owners of pass-through businesses (primarily sole proprietorships, partnerships, and S corporations) to deduct up to 20 percent of the qualified business income from their taxable income. The QBI deduction is generally available to most taxpayers with pass-through business income whose 2018 taxable income is at or below $315,000 for joint returns and $157,500 for other filers. Taxpayers with incomes above these levels may still be eligible for the deduction but may be subject to limitations based on the type of trade or business, the amount of W-2 wages paid in the trade or business, and the unadjusted basis immediately after acquisition of qualified property. These limitations are fully described in the final regulations and were the subject of earlier blog postings this month.

When Congress created this deduction, it stated that to claim the Section 199A deduction on rental real estate the activity must be deemed to be a trade or business. This indicates that some rental activity such as activities engaged in by a real estate professional (as that term is defined under the passive activity rules in Publication 925 ) would qualify for the deduction, and certain real estate activity held by passive investors would not qualify. This lack of definition created the uncertainty for the QBI deduction for the taxpayers with real estate rental activities but at a level that falls short of meeting the tests for a real estate professional under passive activity rules.

In their Friday release, the Treasury Department and the IRS recognized that their prior pronouncements on whether a rental real estate enterprise is a trade or business was the subject of uncertainty for some taxpayers. To help mitigate this uncertainty, the IRS has issued a new proposed revenue procedure that will provide a safe harbor under which a rental real estate enterprise will be treated as a trade or business solely for purposes of the section 199A deduction. This safe harbor is contained in Notice 2019-07 and it requires the following:

First, the taxpayer must maintain separate books and records that reflect the income and expenses for each rental real estate enterprise. Solely for the purpose of this safe harbor, a rental real estate enterprise is defined as an interest in real property held for the production of rent and it may consist of an interest in a single property or multiple properties. The taxpayer may treat each rental property that it holds as a separate rental real estate enterprise or the taxpayer may treat all their real property as a single rental real estate enterprise for Section 199A deduction purposes. However, commercial and residential real estate may not be part of the same rental real estate enterprise. Once the taxpayer makes this determination regarding the treatment of the rental property, they cannot change it from year to year unless they can demonstrate a significant change in facts and circumstances.

Second, starting with the 2018 tax year, 250 hours of rental services must be performed with respect to the rental real estate enterprise. Rental services can be performed by the taxpayer or by others hired by the taxpayer. For the purpose of this safe harbor, rental services will consist of (i) advertising to rent or lease the real estate; (ii) negotiating and executing leases; (iii) verifying information contained in prospective tenant applications; (iv) collection of rent; (v) daily operation, maintenance, and repair of the property; (vi) management of the real estate; (vii) purchase of materials; and (viii) supervision of employees and independent contractors.

Third, starting in 2019, the taxpayer will be required to maintain contemporaneous records, including time reports, logs, or similar documents, regarding the following: (i) hours of all services performed; (ii) description of all services performed; (iii) dates on which such services were performed; and (iv) who performed the services. In future years, the IRS may request these records, but for the 2018 tax year this provision is not in effect.

Finally, to utilize this safe harbor the taxpayer must attach a statement to the tax return that the requirements of this safe harbor provision have been met. This statement must be signed by the taxpayer and state that “Under penalties of perjury, I (we) declare that I (we) have examined the statement, and, to the best of my (our) knowledge and belief, the statement contains all the relevant facts relating to the revenue procedure, and such facts are true, correct, and complete.”

The IRS also announced in the Final 199A Regulations that for the purpose of the Qualified Business Income Deduction the deductible part of the self-employment tax, the self-employment health insurance deduction and any contributions that a taxpayer makes to a self-employed SEP, SIMPLE and/or qualified plan must be taken into account when computing Qualified Business Income. The provisions of Notice 2019-07 and the new provisions contain in the final regulations will be incorporated into the tax program shortly.