Posts Tagged ‘QBI deduction’

Final 199A Regulations

The Section 199A deduction requires you to be a trade or business. Follow these rules to take advantage of this generous deduction on your rental properties.

The Section 199A deduction requires you to be a trade or business. Follow these rules to take advantage of this generous deduction on your rental properties.

The IRS released final regulations on 199A. The Kiplinger Tax Letter said it best: “Final regulations provide limited guidance, but IRS gives a safe harbor.”

In this post we will discuss the safe harbor as it relates to “trade or business” with special emphasis on application with rental properties. The safe harbor doesn’t apply to all taxpayers and the trade or business designation is still possible without meeting the safe harbor parameters.

The final regulations run 248 pages. I will follow this post with a detailed post on 199A tiers with several decision trees. Due to the length and complexity of the regulations we are forced to remain focused on one aspect of 199A. Taxpayers with a sole proprietorship, partnership, S corporation or investment property may wish to seek the services of a competent tax professional until more clarification is reached through more regulations or from the Tax Court.

Links are provided at the end of this post to the entire 248 pages of regulations released and Notice 2019-07 (only 10 pages!) dealing with the trade or business safe harbor for real estate issues for your further research.

 

Remaining Problems with the Final Regulations

The final regulations refer to Section 162 (as previous releases have). Section 162 generally governs the deductibility of expenses for a trade or business. But Section 162 is unclear when it comes to rental activities. 

The reason for the vagueness is because the facts and circumstances of each taxpayer differs. Whether the property is commercial or residential, the lease terms, services provided, how many properties owned  and day-to-day involvement in the activity all play a role. We will touch on each of these throughout this post. 

The biggest problem with the final regs is that they were issued after 2018 was in the books. Nobody knew they needed to keep track of time spent in the activity, nor did they know they were required to keep a separate bank account for the rental activity.

The IRS, aware of this, has granted some leeway for the 2018 tax return as it regards contemporaneous records.  However, for tax years beginning after December 31, 2018 you must follow the new regs for record keeping. Ignorance is not an excuse.

Once the IRS laid out the safe harbor for a “rental real estate enterprise” they state: 

Failure to satisfy the requirements of this safe harbor does not preclude a taxpayer from otherwise establishing that a rental real estate enterprise is a trade or business for purposes of
section 199A.

This means the safe harbor isn’t the only way to take advantage of the generous 199A deduction. 

If you use the safe harbor you must include a statement to that effect with the tax return. Qualified pass-through entities (RPEs) can also use the safe harbor and provide the taxpayer with the required statement that application of the safe harbor was used as outlined by regulations. This is attached to your return.

 

Safe Harbor

The new deduction for rental property owners is no game. Get your deduction today.Rental Real Estate Enterprise: For purposes of the safe harbor the IRS uses the term rental real estate enterprise, defined as an interest in real property held for the production of rents and may consist of an interest in multiple properties. 

The individual or pass-through entity relying on this safe harbor must hold the interest directly or through a disregarded entity. This means you can only use the safe harbor if you hold the property personally or as an LLC treated as a disregarded entity. If you hold the property in an LLC electing to be treated as an S corporation (and there is no reason to ever hold real estate in an S corp) you cannot use the safe harbor.

The taxpayer must treat the property (or group of properties) held for the production of rents as a separate enterprise. This means you hold each property or group of properties as a single enterprise. Which means you have a separate bank account and name for the enterprise. Those with multiple LLCs could experience issues with qualifying for the safe harbor. 

Commercial and residential property cannot be part of the same enterprise. Yes, this can cause real confusion when you have mixed property under one LLC and/or business name. As I read this regulation you would need to qualify for the safe harbor for both the residential and commercial property.

Once you establish a treatment for your properties (which properties belong with each enterprise) you must continue with the same treatment unless there has been a significant change to the facts and circumstances (sale or purchase of property, for example).

Safe Harbor Defined: For the Qualified Business Income Deduction only, 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:

  1. Separate accounting of income and expenses are maintained for the rental real estate enterprise.
  2. 250 or more hours of rental services are performed for taxable years beginning prior to January 1, 2023 with respect to the rental enterprise. 
  3. For taxable years beginning after December 31, 2022, 250 or more hours performed in respect to the rental real estate enterprise in any 3 of the 5 prior consecutive years.
  4. Contemporaneous records are required, including: time reports, logs and similar documents regarding the following:
    1. hours of all services performed
    2. description of all services performed
    3. dates services were performed, and
    4. who performed the services

Of course, contemporaneous records are a bit hard to produce when the rules were not in place until after the tax year concluded, and therefore the records do not need to be contemporaneous for tax year 2018. I recommend going over 2018 ASAP to create a log of all services performed.

 

What Counts for the Safe Harbor

Not all activities count toward the 250 hour requirement for the safe harbor. 

Rental services performed by the taxpayer or by employees, agents, and/or independent contractors of the taxpayer all count toward the 250 hour safe harbor requirement. 

Rental services for the rental real estate safe harbor include:

  1. advertising to rent or lease the property/s
  2. negotiating and executing leases
  3. verifying information from prospective tenants
  4. collection of rents
  5. daily operation, maintenance and repair of the property/s
  6. management of the property/s
  7. purchase of materials
  8. supervision of employees and independent contractors.

Keep in mind the time supervising employees and/or contractors only includes your time supervising. The hours performing services by employees and independent contractors do not count toward your hours.

 

Activities that Don’t Count as Rental Services

Several activities do not count as rental services as applied to the 250 hour requirement:

  1. travel to and from the property/s
  2. financing activities
  3. investment management activities (financial statement review; property search; and procuring and planning, managing or constructing long-term capital improvements)

Generally, things that are easily fudged are disallowed. Saying you spent many hours reviewing the books or driving to the property will not benefit you. Saying you spent x number of hours planning capital improvements to the properties also do not count toward the safe harbor.

 

Other Exclusions

Real estate is better than ever with the new tax laws. Discover the advantages to 199A. Get your tax break today.Several situations are excluded from using the safe harbor. 

Any personal use of the property during the year excludes use of the safe harbor.

Triple-net leases are also excluded from the safe harbor. A triple-net lease is defined as a lease agreement that requires the tenant to pay for all or part of the taxes, fees and insurance, and the tenant is responsible for 

maintenance requirements in addition to rent and utilities. Since most commercial property is leased triple-net, the safe harbor option is unavailable, but may still qualify as a trade or business as shown next.

 

How to Still Claim as a Trade or Business

Since so many tax dollars are riding on the line it is important to determine if you qualify for the 199A deduction. The safe harbor is just that, a safe harbor. Just because you don’t qualify for the safe harbor does not mean you do not have a trade or business.

There are some similarities in this safe harbor with the material participation tests under the passive activity rules. While the numbers between this safe harbor and the material participation tests are different, we can still gather guidance by reviewing the facts and circumstances in determining if the activity is a trade or business.

Earlier last summer while waiting for the IRS to provide guidance on what a “trade or business” is, I decided to build a policy for my office. My conclusion was that investment property (reported on Schedule D when sold) was not a trade or business and property that is treated as a sale of business property when sold (reported on Form 4794) is a trade or business. With the recent IRS guidance I am forced to tighten my definition of a trade or business in situations not covered by the safe harbor.

The IRS actually uses the words “trade or business activities” in their material participation tests. In other words, they say:

You materially participated in a trade or business activity for a tax year if you satisfy any of the following tests:

Whereas the safe harbor for 199A rental services say you need 250 hours, the first material participation test says 500 hours. I think it is safe to say we can use 250 hours when not using the safe harbor as well.

But you can still be a trade or business if you put in fewer than 250 hours if the material participation tests are a valid ancillary. 

Material participation test #3 says if you put in 100 hours, and is more than anyone else in the activity, you pass the test and materially participate.

According to test #2, if you put in substantially all the participation in the activity you pass.

There are additional tests to determine material participation. For trade or business issues I think it is reasonable to use the material participation guidelines, whether it be a small business or rental property. The safe harbor is a bit easier to pass for 199A based on hours, but if you meet the guidelines in any of the material participation tests you have substantial grounds for claiming you are a trade or business since the IRS already recognizes this in another area of tax application.

 

Final Considerations

Section 199A, the Qualified Business Income deduction is one of the most complex pieces of legislation to hit taxpayers in a long while. I dealt with one narrow subsection of the regulations. 

It might be a good idea to hire a tax professional for at least one year if you own a business and or rental property to deal with the litany of tax issues surrounding 199A. Even if an extension is required and your taxes are not filed until later in the year.

Here are a few issues not covered in this post that you will want to discuss with your tax professional:

  • Tier #1, #2 and #3 for small businesses
  • Specified service trades or businesses (SSTB)
  • Form 1099 (If a rental in not a trade or business then Form 1099 reporting can sometimes be avoided. However, you want to be a trade or business for 199A reasons so if you don’t file Form 1099 with contractors the IRS may disallow the deduction because you didn’t act like a trade or business)
  • Contributed property to an entity has special rules
  • Special rules apply to like-kind exchanges and involuntary conversions
  • Special considerations for basis of inherited property
  • Net operating losses affect 199A
  • Capital gains and losses may affect 199A
  • Amended returns are not allowed to initiate aggregation, but aggregation can be used in future years
  • SSBTs are better defined in the final regulations
  • and more. . . 

 

As promised, here are the reports from the IRS. You can read Notice 2019-07 as well as I. It is a short 10 page document and worth a read if you have rental properties. Less readable is the final regulations on 199A, coming in at 248 pages.

If you ever have trouble falling a sleep one evening just pick up the final regs. You’ll be out cold in minutes.

 

 

More Wealth Building Resources

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Side Hustle Selling tradelines yields a high return compared to time invested, as much as $1,000 per hour. The tradeline company I use is Tradeline Supply Company. Let Darren know you are from The Wealthy Accountant. Call 888-844-8910, email Darren@TradelineSupply.com or read my review.

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The IRS Issues Proposed Regulations on the Qualified Business Income (QBI) Deduction

The IRS is true to their word when they said they’d issue regulations on the Qualified Business Income Deduction, otherwise known as QBI, by the end of summer. In the past week proposed regulations were published, coming in at 184 pages. Remember these are “proposed” regulations. Final regulations come after guys like me pick it apart. Most of what you see probably survives so it is a good time to start the planning process.

Accountants who wanted to get a jump-start advising clients on ways to maximize the deduction are in for a rude surprise. Most schemes are out. At the end of this post I will outline what can be done to maximize the deduction.

The 184 pages of proposed regs cover more than just QBI. We will discuss the most relevant here. Consider consulting with a tax professional to review how your personal situation is affected by these proposed regulations.

If I find any other juicy tidbits, I’ll publish. If not, I’ll wait until the final regs are issued.

Who Qualifies?

First, let’s clarify what the QBI deduction is. The QBI deduction is a 20% non-cash deduction for qualified business income (generally profits) for small businesses (sole proprietors, LLCs, S corporations, partnerships and some trusts) and income property investors.

The IRS confirmed what I suspected when they said QBI applies to self-employed persons, along with pass-through entities (S corps, partnerships, LLCs) and certain trusts. I think there is room for debate of the sole proprietor issues, but if the IRS gives the green light I’m happy to oblige. QBI is also available for income property owners with somewhat different rules.

Some issues the IRS clarified are pretty straight forward from H.R. 1. Phase out of the deduction starts at $315,000 for joint returns and $157,500 for the rest of the crowd if the business is in a listed field. The deduction is reduced to zero for that business once income exceeds $415,000 for joint returns; $207,500 for other returns.

The fields restricted by the above phase out are:

  • Health
  • Law
  • Accounting
  • Consulting
  • Performing Arts
  • Actuarial Science
  • Athletics
  • Financial/Brokerage/Investment Management/Securities Trading/Securities Dealers

One issue worth pointing out is the phase out is applied per business! This opens a potential planning opportunity where you break a larger company into parts to fall under the limits. Except the IRS knows this trick already and nixed it.

You deserve every legal deduction allowed. Pat the lowest amount of taxes legally, including the new tax bill. Investment property owners and small businesses have more deductions than ever, included non-cash deductions. #cash #deduction #taxes #taxdeductions #legaldeductionsThis doesn’t mean you can’t have multiple businesses. QBI is calculated separately for each business, but if the same owner/s has two or more similar businesses they are combined in many cases! The “bust the company into a bunch of littler companies” idea doesn’t work.

Small businesses are still punished in a way for raising employee wagesItems I published previously are correct.

And talking about wages: enterprising tax professionals may have advised you to fire employees and hire them back as independent contractors. This way the old employees are really business owners and get a 20% deduction on their wages. The IRS has made clear this will NOT be allowed. This and similar schemes will be pursued and denied by Revenue. Penalties and interest will apply. You’ve been warned.

Investors in Real Estate Investment Trusts (REITs) have clarity with the proposed regs when claiming QBI. I’ll discuss this in a future post closer to tax season as the planning opportunities are limited for most taxpayers.

S corporations exclude reasonable compensation to owners when calculating QBI. The same applies to guaranteed payments to partners. Every idea I’ve seen to game the system involving owner’s compensation is clarified in the proposed regs and not allowed. But there are legal ways to maximize QBI.

Legal Ways to Increase QBI

Fancy footwork may seem the way to go when dealing with the new tax rules, but the old reliable methods of reducing income have a better chance having stood the test of time.

Lowering your income if you are already below the phase out has less benefit than in the past as business deductions are technically only worth 80 cents on the dollar. (You get a 20% deduction anyway if you don’t invest in the expense.) Below the phase out you need to consider the long-term effects on your tax situation. Additional equipment purchases or promotional expenses may not be the best choice when you consider the reduced profits mean a reduced QBI deduction. Example: You elect to spend an additional $10,000 on advertising. The additional deduction is only $8,000 since you would have received a $2,000 QBI deduction anyway.

The phase out is where things really get interesting. If you’re reasonably close to the phase out threshold, a modest amount of planning could make the difference between the full QBI deduction and no deduction at all. Remember, you can’t just increase your paycheck (assuming you are an owner receiving reasonable compensation) to reduce the company profits since reasonable compensation isn’t considered when calculating QBI. Let’s start with some small things and work up to large deductions you can take to qualify for the QBI deduction.

Office in the home: Sole proprietors can deduction a regular and exclusive office in the home using actual expenses or the safe harbor of $5 per square foot, up to 300 square feet. This is more valuable than in the part with the standard deduction much higher and state and local taxes (SALT) deductions limited on Schedule A.

The qualified business income deduction is complicated. Guarantee you get the maximum value for your tax deduction. Tax planning can save more than ever. Maximize your QBI deduction here. #QBI #qualifiedbusinessincomededuction #tax #taxes #taxdeductions #business #businessdeductionsMissing deductions: It might sound strange, but many business owners forget to take all their deductions. Business miles are deductible. Keep a log book in your vehicle so every mile is counted. Small cash payments for business expenses add up. Track them all.  Any expense related to the business should be included. The IRS used “ordinary and necessary” as their term for what is allowed as a business expense. This is a wide road.

Section 1.263(a)-1(f) de minimis election: The de minimis election allows you to deduct all items that would normally be depreciated under $2,500. This is per item! For businesses this doesn’t mean much as bonus depreciation (more on this later) allows much larger deductions. But income property owners benefit mightily! Most stoves and refrigerators are under $2,500. Expensing anything connected to real estate under Section 179 isn’t allowed, even stoves and refrigerators. For most taxpayers this is a moot point as bonus depreciation counts for all assets with a class life of 20 years or less. But, many states limit Section 179 depreciation or don’t exactly follow federal tax rules for bonus depreciation. To my knowledge, all states follow this de minimis election, thereby bypassing Section 179 and bonus depreciation issues. Note: you can clean your depreciation schedule, too. Previous items under $2,500 can be currently expensed if the election is made. This could be a sizable deduction if you have a lot of small items on your depreciation schedule from prior years.

Repair Regs: Section 1.263(a)-3(h) election: This election allows for a deduction of up to $10,000 for an improvement as a repair. Property improvements do not fall under the bonus depreciation rules. Example: a bathroom or kitchen in an office or income property is probably an improvement by most measures and therefore depreciated over 27.5 or 39 years. If the remodel is $10,000 or less (per remodel or improvement) you can elect to treat the improvement as a repair and expense the entire amount. This is important. You might have a deck on a property replaced for $3,000, a roof for $9,000 and a minor bathroom remodel for $6,000. Each is a separate event. Each is under $10,000. You can elect for each improvement (you make multiple elections for multiple improvements) to deduct the amount as a repair expense. In this case the total repair expense deducted is $18,000.

Bonus depreciation: Bonus depreciation is back at 100% for assets with a class life of 20 years or less. This is by far the easiest way to chew huge chunks of reportable profit from a business. The decision for a machine shop to purchase a new piece of equipment this year or next for $200,000 will require a review of the current circumstances. If this year’s profits are too high for the QBI deduction, it might be advantageous to purchase the equipment this year. If not, you can save the purchase for next year. Facts and circumstances will prevail. If there is one area to get creative, it’s here. One caveat: restaurant, retail and leasehold improvements (qualified improvement property) acquired and placed in service between September 28, 2017 and December 31, 2017 get the 100% bonus depreciation, but not afterwards unless the tax law glitch is fixed. Don’t hold your breath.

 

I don’t want to get any longer on such a technical post. I just want you to understand there are many ways to take advantage of the current tax environment. The proposed regulations cover a wide variety of material. When the regs finalize I’ll publish more.

Until then, feel free to leave questions in the comments. I’ll answer the best I can with the limited information you provide me and as time permits. As previously noted, the proposed regs run 184 pages. I focused on the issues affecting my clients most. There are lesser issues that also affect clients I didn’t touch on. For example, I didn’t touch on the “reputation or skill” clause as it relates to QBI.

To keep this blog readable I’ll break up the technical tax posts with plenty of entertaining and useful wealth building, early retirement, side hustle and frugal living posts. It’s always good to have a family friendly blog.

 

More Wealth Building Resources

Personal Capital is an incredible tool to manage all your investments in one place. You can watch your net worth grow as you reach toward financial independence and beyond. Did I mention Personal Capital is free?

Side Hustle Selling tradelines yields a high return compared to time invested, as much as $1,000 per hour. The tradeline company I use is Tradeline Supply Company. Let Darren know you are from The Wealthy Accountant. Call 888-844-8910, email Darren@TradelineSupply.com or read my review.

Medi-Share is a low cost way to manage health care costs. As health insurance premiums continue to sky rocket, there is an alternative preserving the wealth of families all over America. Here is my review of Medi-Share and additional resources to bring health care under control in your household.

QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. QuickBooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.

A cost segregation study can save $100,000 for income property owners. Here is my review of how cost segregations studies work and how to get one yourself.

Amazon is a good way to control costs by comparison shopping. The cost of a product includes travel to the store. When you start a shopping trip to Amazon here it also supports this blog. Thank you very much!