Real estate investors have heard a lot about the new 20% pass-through deduction, technically called Section 199A. But will your rentals qualify? In releasing the final regulations on Section 199A, the IRS did clarify that rentals must rise to the level of a trade or business under Section 162 in order to take a 20% deduction on the rental income. This article will provide some insight as to how your rentals can rise to the level of a Section 162 trade or business and qualify for the 20% pass-through deduction.
Understanding Section 162
The Section 162 standard requires that a business activity be conducted regularly and continuously for the primary purpose of earning a profit. The problem is that, historically, there's no bright line test for when a rental rises to the level of a Section 162 trader business. When the IRS released the final regulations in January 2019, they also produced a safe harbor. To easily qualify your rentals as a trade or business, see if they meet the safe harbor requirements under Revenue Procedure 2019-7. Under the safe harbor, rental activity will rise to the level of a section 162 trade or business if more than 250 hours of rental services are performed each year with respect to the rental real estate enterprise. Separate books and records are kept with respect to each rental real estate enterprise and you maintain a time log describing the time that you spent on each rental real estate enterprise, the dates that the services were performed, and who performed the services.
The 250 Hour Requirement
We need to understand what does count and what does not count towards that 250-hour requirement for rental services. Rental services are advertising, negotiating, processing tenant applications, collecting rent, daily operations, management, supervision of contractors and employees. It's important to note that the hours that your agents, property managers, contractors, employees spend on your rental activities also count towards your 250 hours. Rental services do not include financial or investment management activities, such as arranging financing, studying, reviewing financial statements, planning, managing, or constructing long-term capital improvements, or hours spent traveling to and from your real estate. The second requirement under the safe harbor is that you maintain separate books and records for each real estate rental enterprise. The third requirement under the safe harbor is that you have to maintain a log of your time and hours spent in each rental real estate enterprise including dates on which the services were performed and who performed the services.
Qualifying As A Real Estate Professional
Qualifying as a real estate professional can allow you to write off an unlimited amount of passive losses against your other income. In order to deduct your passive losses in an unlimited amount, you must first qualify as a real estate professional and also demonstrate that you materially participated in your rental real estate activities. To qualify as a real estate professional you have to spend at least 750 hours in a real estate trade or business and you also must spend more than one-half of your time in a rental real estate trader business in which you materially participate. Once you qualify as a real estate professional, you have to then demonstrate material participation in the rental real estate activities. There are seven tests for material participation. The three that we most often see are that you spend 500 hours in your rental real estate activity or your participation makes up substantially all of the participation related to that rental real estate activity during the year or you participate at least 100 hours and more than anybody else during the year.
One of the key requirements is to keep a time log that details your activity related to your rental real estate. Landlords who don't keep great records often get nailed by the IRS; worst case the real estate professional election can be reversed. All of those tax savings will be flushed down the toilet!
To illustrate, let's explore a court case where a taxpayer, who claimed the real estate professional, was able to successfully defend her position, but not without a scolding from the Tax Court.
Birdsong v. Commissioner of Internal Revenue
Roberta Birdsong had two rental properties consisting of four units and five units. In 2014, Roberta was the sole party actively engaged in the day-to-day management activities of these two rentals. She performed all the tasks including cleaning, repairs, communicating with tenants, collecting rents, maintaining insurance policies, purchasing materials, managing contractors, and keeping the books and records. Roberta produced two spreadsheets at the tax court related to her 2014 activities. The first included 845 hours and the second included 1136 hours and included activities that she had left off the first spreadsheet. The problem that both the IRS and the tax court found is that Roberta built these time logs retroactively.
The result of the court case was that Roberta actually kept really good records. She just didn't keep her time log contemporaneously during 2014. The tax court actually disagreed with the IRS that the time log should be thrown out and did uphold Roberta's real estate professional election. However, the tax court did issue a pretty stern warning to Roberta about keeping contemporaneous records going forward.
You have to be consistent in how you apply your trade or business tests. One of the problems with this 20% deduction is that one rental might be producing net passive income while another rental might be producing net passive losses. Just because one rental is producing net passive losses does not mean that it does not rise to the level of a trade or business. So, if you apply either the safe harbor or your trade or business test to any one rental, you have to apply it across the board to all of your rentals in a consistent manner. You can't really say that just because a rental produces a passive loss that it doesn't rise to the level of a trade or business simply so that you can boost your 20% pass-through deduction.
Some rental real estate is excluded from this safe harbor. Rental real estate that you also occupy as your primary residence does not count towards this safe harbor. Any property rented on a triple net lease basis is excluded from this safe harbor. While these activities don't count for this safe harbor, it doesn't mean that you can't separately qualify these activities as a section 162 trade or business - it just makes it a lot harder.
If your rentals do rise to the level of a trade or business, you need to issue 1099s at the end of the year. You'll have to issue a 1099 to anybody that you pay in excess of $600 during the year unless that company is a corporation, excluding medical offices and attorneys.