Tax Saving Tips for Your Rental Properties - Summer 2019
Submitted by Desmond Wealth Management, Inc. on June 8th, 2019Here are a few tips for saving on taxes for your rental properties. Did you know that the Tax Cuts and Jobs Act created a 20% tax deduction possibility? A new "Safe Harbor" has also been made for Section 199A rental properties. If you've wondered how to handle multiple rental activities and the 199A deduction, you'll find information on that here, as well.
Good News: Most Rentals Likely Qualify as Section 199A Businesses
The Tax Cuts and Jobs Act tax reform added new tax code Section 199A, which created a 20 percent tax deduction possibility for you if your rental property (a) has profits and (b) can qualify as a trade or business.
As the law now stands, with rentals that achieve trade or business status, you win. Your business-status rental property creates the following five possible tax benefits for you:
- Your rental property can create a Section 199A tax deduction of up to 20 percent of the rental property’s qualified business income.
- Your rental property receives tax-favored Section 1231 treatment, which (upon sale) delivers with a tax loss — an ordinary loss (the best kind of loss) — and with a tax-favored capital gain (the best kind of gain).
- Your rental property can create the home-office deduction if you meet the other home-office requirements of exclusive and regular use.
- Your rental-business status creates rental property deductions for the cost of your attendance at rental property meetings, seminars, and conventions.
- Your rental-business status enables Section 179 expensing for certain assets used in the business (special rules apply to the real property).
To obtain the benefits listed above, you must have a rental property that qualifies as a trade or business.
IRS Creates a New “Safe Harbor” for Section 199A Rental Properties
The Section 199A 20 percent tax deduction is a gift from lawmakers — literally. You don’t earn this deduction; it’s simply there for you if you qualify.
Under the trade or business rule, your rental property profits can create the deduction, and now, under an alternative rule, you can use the newly created IRS safe harbor to make your rentals qualify for the deduction.
When you meet the new safe-harbor rules, the IRS deems your rental a trade or business with net rental profits that are QBI for the Section 199A tax deduction. However, you may not want to use the safe-harbor rules, because they contain some onerous provisions. Also, you may not qualify to use the safe harbor – but no problem. You can simply use the second method and win your 199A tax deduction using the existing trade or business tax law rules.
Under the new Section 199A rental real estate safe harbor (and only for this Section 199A safe harbor), each of your rental real estate properties individually or as a group (if you so choose) falls into one of the following categories:
- Residential real estate enterprise
- Commercial real estate enterprise
- Triple net lease real estate
Grouping rule: You (or your pass-through entity) must either
- Treat each rental property as a separate enterprise, or
- Treat all similar properties as a single enterprise.
Example: You have 10 rentals: eight are residential, and two are commercial. None are triple net lease. With grouping, you have two enterprises: one residential and one commercial.
With grouping of the residential and no grouping of the commercial, you have three enterprises: residential, commercial 1, and commercial 2. (Reminder: You don’t have to use the safe-harbor rules for your rental properties. You can use the historical trade or business rules.)
Safe-Harbor Requirements
Solely for Section 199A purposes, the IRS will treat your rental real estate enterprise as a trade or business if you (or your pass-through entity) can satisfy the following requirements:
- You maintain separate books and records that reflect the income and expenses of each rental real estate enterprise.
- You perform 250 or more hours of “rental services” during the tax year.
- You 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. (Note: The contemporaneous records rule does not apply to tax years beginning before January 1, 2019 — but don’t let this give you false hope; you still need proof.)
Rental Services
Qualifying defined “rental services” can be done by you, your employees, your agents, and/or your independent contractors. Such services include:
- Advertising to rent or lease the real estate.
- Negotiating and executing lease.
- Verifying information contained in prospective tenant applications.
- Collecting rent.
- Operating, maintaining, and repairing the property.
- Managing the real estate.
- Purchasing materials.
- Supervising employees and independent contractors.
Rental services that do not qualify for the safe harbor include:
- Financial or investment management activities, such as arranging financing, procuring property, or studying and reviewing financial statements or reports on operations.
- Planning, managing, or constructing long-term capital improvements.
- Hours spent traveling to and from the real estate.
Reminder: The safe-harbor rules above are solely for Section 199A purposes.
Beware: The passive-activity rules for material participation and status as a real estate professional contain many differences from what you see for the Section 199A tax deduction.
Time log: Your number-one important record for obtaining hassle-free tax deductions on your rental real estate is an accurate and provable time log. If you are using the new Section 199A safe harbor, you now have one additional reason to track time spent.
Nonqualifying Real Estate
Triple net lease property does not qualify for the safe harbor. Remember, the safe harbor is not the only method you can use to qualify your rental real estate for the Section 199A tax deduction.
Also, you may not use the safe harbor on real estate that you use as a residence. If you have a vacation home, Section 280A makes that vacation home either a rental property or a residence.
Safe Harbor — No 1099 Issues
If you use the safe harbor, your rental is a business regardless of whether you send 1099s to service providers. In its preamble to the final Section 199A regulations, the IRS notes that the law requires a trade or business to send 1099s to certain service providers.
Final Thoughts
You may not find it easy getting to the safe harbor, but remember, once you are inside the safe harbor, you have the comfort of knowing that your rental properties are business properties for the possible 20 percent tax deduction under Section 199A. Now, because of the safe harbor, you have a choice:
- Use the safe harbor, or
- Use the existing tax code trade or business rules to prove that your rental is a trade or business.
Remember, once you are inside the safe harbor, the fact that you did or did not issue 1099s to your service providers is moot for purposes of the Section 199A tax deduction.
How to Handle Multiple Rental Activities and the 199A Deduction
There’s a lot of confusion out there around your rental activity and Section 199A. Your Section 199A considerations multiply when you have multiple rental activities. Here’s what you need to consider:
- Are your rental activities multiple trades or businesses, or one trade or business?
- Can you aggregate the rentals for Section 199A purposes? Do you want to?
- How does the Section 199A rental safe harbor impact your Section 199A deduction if you use it?
Whether your rental activities are each a trade or business, or they constitute one trade or business, is inherently based on the facts of your particular situation. The IRS also believes that multiple trades or businesses will generally not exist within an entity unless it can use different methods of accounting for each trade or business under the Section 466 regulations. These regulations explain that you can’t consider a trade or business separate and distinct unless you keep a complete and separable set of books and records for that trade or business.
This determination is an important factor for you if any one rental activity (taken individually) doesn’t rise to the level of a trade or business, but all the rental activities (viewed collectively) do rise to the level of a trade or business. One of the factors the IRS looks to when determining whether a rental activity is a trade or business is the number of properties rented.
Aggregation
The Section 199A regulations allow you to aggregate multiple trades or businesses such that you treat the aggregated group as one trade or business for determining your Section 199A deduction. This is an important consideration if one or more of your rental businesses have insufficient wages or unadjusted basis in assets (UBIA) to get the maximum Section 199A deduction for that property.
The final regulations tell us you can aggregate, in most circumstances, provided that the rental activities share centralized administrative functions, such as accounting, legal, and human resources functions. The big wrinkle is the type of rental business: you generally can’t aggregate residential rental businesses and commercial rental businesses with each other because they aren’t the same type of property.
Rental Safe Harbor
Along with the final regulations, the IRS gave you an optional safe harbor to deem your rental activities as qualifying for the Section 199A deduction. The safe harbor isn’t the best strategy because most rentals qualify as a trade or business anyway.