The new 20% pass-through deduction in the 2017 Tax Cuts and Jobs Act is one of the major benefits of the new tax plan, and it has big benefits for real estate companies. If 250 hours of services are performed in a taxable year, rental real estate treated as a trade or business entitled to the deduction. Owners will be able to structure leases and operations to best take advantage of the new deduction. This news, however, comes from a proposed revenue procedure, rather than from the IRS.
“The IRS declined to adopt a position that all rental real estate activity is deemed to be a trade or business for purposes of the 20% deduction,” Phil Jelsma, a partner and chair of the tax practice team at Crosbie Gliner Schiffman Southard & Swanson, tells GlobeSt.com. “However, under a proposed safe harbor in Notice 2019-07, which is a proposed Revenue Procedure, rental real estate is now treated as a trade or business entitled to the deduction if at least 250 hours of services are performed each taxable year with respect to the real estate enterprise. This includes services performed by employees, owners and independent contractors as well as time spent on maintenance, repairs, collection of rent, payment of expenses, provision of services to tenants and efforts to rent the property.”
There are a number of rental services include in rental for safe harbor. Jelsma lists those to include advertising to rent or lease the property or properties; negotiating and executing leases; verifying information from prospective tenants; collection of rents; daily operation, maintenance and repair of the property or properties; and, finally, supervision of employees and independent contractors. Additionally, there are several activities that will not count as rental services and cannot be applied to the 250 hours. Those include travel to and from the property or properties; financing activities; and investment management activities, like financial statement review, property search, procuring and planning and managing or constructing long-term capital improvements. Additionally, the owner's time spent in carrying out investment functions, like arranging financing and procuring property, equally do not qualify.
While these rules apply to rental real estate, triple-net leased assets and assets used by the owner as a primary residence are exempt from the deduction. “Not meeting a safe harbor does not mean that the expenses from the real estate would not otherwise be treated as trade or business expenses,” explains Jelsma. “In one instance, the regulations extend the definition of trade or business for purposes of the 20% deduction beyond the normal rules. Renting real estate to a related person or related party is treated as a trade or business entitled to the 20% deduction. The regulations also have a special rule for single member LLCs whose owners are treated as conducting the business directly.”
The deduction also addresses rental property obtained through a 1031 exchange transaction or a 1033 involuntary conversion. “For purposes of determining the acquisition cost of property acquired in a tax-free exchange, the tax basis as opposed to the acquisition cost is used,” adds Jelsma. “Generally, then, for purposes of calculating the 2.5% of the taxpayer's tax basis from relinquished property will transfer to replacement property unless the taxpayer either receives money or non-like kind property or pays money or non-like kind property in the exchange. The amount entitled to the 2.5% deduction is reduced by cash and received and increased by cash paid.”
These deductions have the potential to create substantial benefits, and Jelsma expects that owners will adopt lease structures that best exploit to the deduction.
“We expect to see real estate owner/operators moving towards gross leases and modified gross leases rather than triple net leases,” he says. “We also anticipate an emphasis on keeping careful tabs on the number of hours spent each year in a real estate trade or business to satisfy the 250-hour per year safe harbor.”
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Kelsi Maree Borland
