For tax years beginning after December 31, 2017, the new federal tax law allows non-corporate business taxpayers to deduct up to 20% of income from a qualified business. This means only 80% of that income will be taxed. This benefit applies to businesses operated as LLCs, partnerships, S corporations, and sole proprietorships. The tax savings inures to the members, partners, shareholders, and sole proprietors of those businesses.
Historically, IRS and taxpayers have quarreled over whether rental real estate businesses qualify for tax benefits otherwise available to other businesses. In large part, IRS considers rental real estate businesses as “passive” and not active businesses. Thus resulting in denial of many tax benefits.
On January 18, 2019, IRS issued a preliminary favorable notice that all rental real estate businesses should review. IRS will formally publish a future Revenue Procedure to adopt or modify the notice. The notice is favorable in that IRS agrees to treat such businesses as qualified businesses for the 20% deduction rule as long as certain requirements are met. The requirements are:
1) Each rental real estate business must maintain separate books and records to report income and expenses;
2) 25o hours or more of “rental services” are performed each tax year; a “rental service” includes: (i) advertising to rent or lease the real estate, (ii) negotiating and executing tenant leases, (iii) verifying information contained in prospective tenant applications, (iv) collecting rent, (v) daily operations, maintenance, and repairing the real estate, (vi) managing the real estate, (vii) supervising employees and independent contractors. Those “rental services” may be performed by the owners or their employees, as well as agents or independent contractors hired by owners. On the other hand, “rental services” will not include certain financial or investment management activities;
3) The taxpayer must maintain contemporaneous records regarding: (i) hours of rental services performed, (ii) descriptions of all rental services performed, (iii) dates such services were performed, and (iv) who performed such services;
4) Real estate rented or leased under triple-net leases will not be considered qualified businesses under the notice. A triple-net lease is an agreement requiring a tenant or lessee to pay real estate taxes, fees, insurance, and maintenance of the real estate;
5) Taxpayers must include a statement attached to the annual tax return, signed under penalty of perjury, that the requirements under the notice (or future Revenue Procedure) have been satisfied.
If all of these requirements are met, IRS will not contest whether the rental real estate business qualifies for the favorable 20% deduction rule. Nonetheless, IRS still reserves the right to examine the tax return and determine whether all requirements have been satisfied.
The IRS notice applies to all rental real estate businesses with tax years ending after December 31, 2017. But the contemporaneous records rule, supra, applies to tax years beginning on or after January 1, 2019.
Hence, all rental real estate businesses conducted as an LLC, partnership, S corporation, or sole proprietorship must, at a minimum, begin documenting rental service hours for 2019 (and beyond) to satisfy the safe harbor rule contained in the notice.
Please contact Howard Richshafer concerning issues or questions concerning the IRS notice.