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Section 199A Rental Property Deduction

Article ID: 397
Last updated: 18 Jan, 2019
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By Jason Watson ()
Posted January 17, 2019

Defining a trade or business is easy for the most part, however certain activities are murky and one of them is rental properties. On one hand an argument that rental property income is already tax advantaged can be made since it is not subject to self-employment taxes (Social Security and Medicare). However, if it were subject to SE tax, people would simply create management entities, elect S Corp status, ding the rental a management fee and achieve a Section 199A deduction that way. This is perhaps one reason the IRS isn’t raising a big stink on rental properties.

Also, in Commissioner v. Groetzinger, 480 U.S. 23 (107 S.Ct. 980, 94 L.Ed.2d 25), the U.S. Supreme Court in 1987 held that for an activity to meet the definition of a trade or business it must be engaged to a) earn a profit and b) with some regularity and continuity. This is also most rental property owners, even if it is just one house.

And… don’t read too much into the words “earn a profit.” This does not mean it must earn a profit… but your intentions for conducting the activity is to earn a profit. Whether you earn a profit or not does not necessarily alter your intentions. Make sense? In other words, “I wanna earn a profit. I’m doing all the right things to make a buck, yo, but right now times are tight and this depreciation thing is killing me.”

The IRS and the Treasury Department recognized this conundrum so they released IRS Notice 2019-7. In that Notice they defined a safe harbor for taking the Section 199A deduction for rental properties-

Solely for the purposes of section 199A, a rental real estate enterprise will be treated as a trade or business if the following requirements are satisfied during the taxable year with respect to the rental real estate enterprise:

  • Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise;

  • For taxable years beginning prior to January 1, 2023, 250 or more hours of rental services are performed (as described in this revenue procedure) per year with respect to the rental enterprise; and

  • The taxpayer maintains 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. Such records are to be made available for inspection at the request of the IRS. The contemporaneous records requirement will not apply to taxable years beginning prior to January 1, 2019.

There are some other devils in the details such as not being able to combine commercial and residential rentals into a single enterprise, and there are lease type rules as well.

Self-rentals pose an interesting situation. For example, you own some equipment personally and lease it back to your business. Provided the arrangement is at market rates, we believe this still qualifies for the Section 199A deduction as a rental business for two reasons. First, how is this any different than an external business who leases the equipment to unrelated parties? That ordinary income would qualify. Second, you are moving dollars from your right pocket to your left pocket, and absent of the SSTB designation, you are just swapping Section 199A dollars.

So, as of right now, rental property owners are able to calculate and use the Section 199A qualified business income deduction if they meet the requirements in IRS Notice 2019-7. This is also where depreciable assets come into play for determining the Section 199A limitations. No, you do not need to pay a W-2 salary from your rental property to enjoy the qualified business income deduction.

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