IRS Safe Harbor for Real Estate – 20% deduction on federal taxes?
Published on: Friday, February 15th, 2019
There has always (apparently) been a discussion in the tax preparer world as to whether income derived from rental properties is considered to be passive income or not. In our mind, based on the vernacular, we would apply the test of whether or not we as investors are actively participating in the rental business itself. I mean, duh…are we actively or passively involved, right? Well…no, that’s not necessarily the case at all. And interestingly, what is relevant to us as managers and to you as clients of a management company is that the time we (agents) spend on your property (be it one property or hundreds) counts. If we (as your agents) are actively participating in the management of your qualified trade or business it counts as if you’re doing it which means you, the investor, would qualify for the deduction…something even your tax preparer may not yet be aware of.
Which beckons the question ‘what is a qualified trade or business?’: The simple answer according to the IRS is ‘A qualified trade or business, with two exceptions…’ The exceptions are not germane to this article. So more importantly becomes the next logical question of whether or not the 199A pertains to you. Well does it?
My understanding (not a tax professional) is that it probably does depending on a couple of factors like income, profession, those exceptions and whatnot. To qualify as a ‘qualified’ trade or business the taxpayer must be actively engaged (material participation) in the business with “continuity and regularity” in pursuit of profit. An oft cited way to determine whether or not a taxpayer materially participates in real estate is the number of hours they work on the business. But check this out, according to Iowa State University:
“The standard is not “material participation,” but conducting the rental activity with “continuity and regularity,” and for the primary purpose of profit. There is no bright-line hour requirement, and the question is highly factual. In the context of cash rent farmland rentals, the question is not whether the landlord is a materially participating farmer[i], but whether the activities of the landlord in managing his or her rental properties are sufficiently continuous and regular. For this purpose, activities conducted by a paid agent are attributed to the owner. See, e.g. Schwarcz, 24 T.C. 733, 739 (1955), acq., 1956-1 C.B. 5. ( The fact that the taxpayer operates the rental property through an agent does not prevent him from being regularly engaged in the business.). This fact-intensive determination is made on a case-by-case basis.”
Again, not a tax profession, but it sure seems that there is a very strong argument that if an investor is using a property manager to manage the property that investor may well be able to lever the Safe Harbor (199A) to get to this tax deduction which is designed to help share the new tax benefits not just to large C corporations, but also to the pass thru entities…that’s the DNA of this law. Here’s why. The Safe Harbor factors that need to be met are almost all included in the services that a property management company offers:
- Maintain separate books and records to reflect income and expenses for each rental real estate enterprise;
- The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, regarding the following:
- hours of all services performed;
- description of all services performed;
- dates on which such services were performed; and
- who performed the services
- And these records must be available for inspection upon request from the IRS, presumably in the case of an audit.
That’s what management companies do and so the property investors/owners should be able to meet the test of “continuity and regularity” assuming the management company has these records…or course.
The bottom line is this…check with your tax professional and make sure they know about this very new 199A Safe Harbor. The government projects it will be woefully underutilized and they’re probably right, but that doesn’t mean you have to be one of the uninformed chaps who miss out.
Oh…and the why; why was this brought about? My understanding is that the recent tax change was applied primarily to C corporations, which doesn’t much effect Main Street, it doesn’t do much (or anything) for small business. This was a way to carry some of the same benefits over to smaller companies.