Guidance on Claiming 20% Rental Deduction

Written by Peter DeMarco | Apr 3, 2019 3:13:16 PM

The Internal Revenue Service recently offered welcome news to some business owners still sorting out the impact of the Tax Cuts and Jobs Act.

One of the key provisions of the tax reform law passed more than a year ago is a 20% deduction of qualified business income from each of a taxpayer’s qualified trades or businesses when operated as a pass-through entity, like a partnership, S corporation or sole proprietorship. As exciting as the deduction sounds, it also produced plenty of questions that the IRS needed to answer to enable people to understand how it would be applied in practice.

One question the IRS recently addressed involved rental income. To qualify for the 20% deduction, income must be generated through a business activity, but rental income can fall into a gray space between business and investment activity.

Consider the difference, for example, between an individual who owns and rents out a single property compared to a large company that owns and operates a group of residential communities. The solo landlord may spend very little time managing that single property, but the business activity to support an entire building full of tenants or sprawling residential complexes can be significant. Commercial real estate enterprises will employ a staff of people to manage and market properties, collect rents, enforce lease agreements and perform necessary maintenance.

Given those extremes, it’s easy to see how the tax rules might say some rental income can be regarded as business income, but some not. Along the continuum, there are lots of facts and circumstances to consider to determine whether a specific rental operation meets the definition of a business for tax purposes.

In light of questions around the new deduction, the IRS recently issued new guidance explaining where it will regard rental income as qualifying for the deduction. The guidance gives taxpayers a safe harbor, a way to be more certain they’re entitled to claim the deduction. The IRS laid out conditions that must be present for it to regard rental income as business income.

First, rental income will be regarded as business income if it’s governed by separate books and records maintained to reflect rental income and expenses for each rental real estate enterprise. As another condition, the IRS established a time threshold of 250 hours as the minimum amount a taxpayer would be expected to spend annually providing rental services.

Finally, a taxpayer must maintain “contemporaneous records,” such as time reports, logs or similar documentation, to show the hours of service performed, the nature of those services, the dates of those services and who performed them. The IRS expects to be able to view those reports when requested, although that documentation won’t be expected for tax years beginning before 2019.

While the guidance is helpful, it comes at a cost. In order to rely on the safe harbor, a taxpayer must sign a statement, under penalty of perjury, asserting their compliance. The documentation to support claiming the deduction under the safe harbor must be pristine or a taxpayer could face big problems with the IRS.

It’s still possible to claim the deduction relying on existing IRS guidance, where the facts and circumstances of a rental arrangement meet the definition of a business. It will be up to taxpayers to determine where their particular scenarios best fit into the tax requirements and then decide on the most appropriate path forward.

Information in this article is based off content from Peter DeMarco's article in Crain's Cleveland Business.

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