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There is exciting news to report on the federal Tax Cut and Jobs Act of 2017, which delivered a basket of goodies to taxpayers. Among those goodies is a 20 percent deduction on qualified business income, which will benefit many individuals that own investment real estate.
The new tax law added Section 199A to the Internal Revenue Code. Like most of the tax code, Section 199A helps some taxpayers (but not all), with new rules, exceptions to rules, exceptions to exceptions to rules and layers of cross-references to other code sections. Further complicating things, the IRS recently issued 247 pages of related regulations, which will challenge the patience of the most wonkish accountants.
All landlords should consult their tax professionals about this deduction, which can be summarized as follows: individuals earning “qualified business income” (QBI) can deduct up to the lesser of 20 percent of QBI, or 20 percent of their taxable income less net capital gains. The deduction is also available to individuals earning QBI from pass-through entities such as partnerships and S-corporations, but not from C-corporations. There are additional restrictions for taxable incomes above $157,500 ($315,000 for couples filing jointly).
IRS regulations for Section 199A make it clear that QBI may include income from rental properties, although taxpayers and their accountants must analyze rental property operations on a case-by-case basis. Fortunately, there is good news for some landlords. In January the IRS issued Notice 2019-07, a straightforward memorandum creating a safe harbor under Section 199A for rental real estate enterprises that maintain separate financial records; perform at least 250 hours per year of “rental services;” and keep detailed records listing hours worked, services performed, dates of services and who performed the services. In other words, individuals who keep careful records and average five hours per week working on their rental properties may qualify for the safe harbor.
Under this safe harbor, “rental services” include advertising rental properties, negotiating leases, verifying tenant information, collecting rent, maintaining and managing properties, and supervising employees and contractors. They may be performed by property owners or their employees, agents and contractors. Rental services do not include financial and investment activities, such as obtaining loans, buying property, reviewing financial information, constructing capital improvements and travel time.
Christopher R. Vaccaro
Triple-Net Leases Not Included
Notice 2019-07 excludes from the safe harbor rental income from triple-net leases. This exclusion impacts commercial leases more than residential leases. Commercial leases commonly have triple-net language, requiring tenants to reimburse landlords for real estate taxes, insurance premiums and maintenance costs.
There are sensible reasons for this rent structure. Commercial leases often entail major investments in tenant improvements, so longer lease terms are needed to recover those investments. During longer lease terms, real estate taxes, insurance premiums and maintenance costs inevitably rise. The increases are difficult to quantify in advance. Triple-net leases allow landlords to avoid erosion of their rental streams, by passing along increased costs to tenants.
It seems illogical to exclude triple-net leases from Notice 2019-07’s safe harbor, but tax laws often defy logic. In any event, even if taxpayers cannot take advantage of the safe harbor, they may still qualify for the Section 199A deduction under the IRS regulations’ more complicated rules. We may also see creative taxpayers use “double-net” leases that would arguably fall within the safe harbor protection.
Notice 2019-07 does help residential landlords. Residential leases are usually short-term arrangements for one year or less, so landlords can periodically raise rents to cover increased costs, without triple-net provisions. Most rents from residential leases will qualify for the deduction, as long as the taxpayer’s taxable income does not exceed Section 199A’s income limits.
The 20 percent deduction phases out for individuals earning taxable income between $157,500 and $207,500 (if they file separately) and $315,000 to $415,000 (if they file jointly). However, even taxpayers with incomes above the phase-out levels may qualify for the QBI deduction, if they own depreciable business assets (including buildings) or pay W-2 wages. The rules are complex, and the availability of Section 199A deductions for those taxpayers is best determined by a tax professional.
Taxpayers who qualify for Section 199A deductions should not get too comfortable with them. Section 199A is among many provisions of the new tax law that will automatically expire in 2026.
Christopher R. Vaccaro is a partner at Dalton & Finegold in Andover. His email address is cvaccaro@dfllp.com.
