As we are in the heat of tax season, lots of talk has been circulating around 199A. A new section in the Tax Cuts and Jobs Act allowing partnerships, limited liability companies (LLCs), S corporations, and sole proprietorships to deduct the sum of 20 percent of their qualified business income (QBI). QBI is the net amount of income, gain, deduction and loss with respect to any qualified business of the taxpayer.
As 199A is a new tax code, navigating whether your business qualifies or not can be complex and require professional help. However, the benefit could greatly impact your business.
Recently, the IRS published the new final regulations of 199A giving us more insight into what is considered a qualified business or trade, especially when it comes to real estate ventures.
Whether a taxpayer’s real estate is a trade or business is an issue that involves analyzing the scope of activities that the taxpayer is engaged in, either personally or through an agent.
Do you qualify?
Despite requests for a factor-based test to determine if your real estate qualifies, the IRS rejected the notion due to the high level of variability and complexity that comes with each situation.
However, the new final regulations do provide four factors to consider when contemplating if your real estate venture qualifies as a trade or business:
- The type of property owned and/or managed by the taxpayer (i.e. commercial, residential, personal)
- The number of properties rented out by the taxpayer
- The day-to-day involvement of the owner or agent
- The type of lease agreement (i.e. triple net, traditional, short-term, long-term)
It is important to understand that case law is the only precedent when navigating these factors, therefore, I advise that you seek professional legal and financial support to properly structure and record your business activities in accordance with these four factors.
Some case laws to review are:
- Hazard v. Commissioner, 1946 – Tax Court ruled that even one single-family rental was a trade or business.
- Neill v. Commissioner, 1942 – Tax Court ruled that the mere collection of rent without any other activity was not enough to constitute a trade or business.
- Hendrickson v. Commissioner, 1987 – Tax Court ruled that a passive investment in an oil-gas did not qualify as a trade or business.
- Schwarcz v. Commissioner, 1955 – Tax Court ruled that a landlord owning, managing and operating apartment buildings was engaging in a trade or business.
Along with the new final regulations, the IRS also released Notice 2019-7 to provide “a proposed safe harbor under which a rental real estate enterprise may be treated as a trade or business solely for the purpose of 199A.”
In order to qualify as a trade or business under the new safe harbor your rental real estate must meet the following criteria:
- Separate books and records are maintained for each rental activity (or the combined enterprise if grouped together).
- Two hundred and fifty hours or more of “rental services” are performed per year for the activity (or combined enterprise).
- The taxpayer maintains contemporaneous records, including time reports or similar documents, regarding hours of all services performed, a description of all services performed, the dates on which such services are performed and who performed the services.
- The notice specifically states that triple net leases are not eligible.
What if you don’t meet the criteria?
If a taxpayer does not meet all of the above criteria, it does not prevent them from arguing that their real estate should qualify as a trade or business. It is important to remember that both the final regulations and relevant case law say that qualifying under Section 199A is determined on a case-by-case basis and responsibility is placed on the taxpayer to show proof.
A 20 percent deduction on your real estate business taxes could provide you the capital to accelerate the growth of your company or provide better compensation to your employees. It is imperative that you find out if your business can be set up to function in accordance with Section 199A.