The Tax Cuts and Jobs Act (TCJA) established a brand new income tax deduction for owners of pass-through businesses, which includes most landlords. If you qualify, you may be able to deduct up to 20% of your net rental income from your income taxes. This deduction begins for 2018 and is scheduled to last through 2025.
Unfortunately, this deduction can be complex. To qualify for the deduction, you must:
There is one more requirement that could prove a stumbling block for some smaller landlords: To claim the pass-through deduction, your rental activity must constitute a business for tax purposes, not an investment activity.
Surprisingly, neither the IRS nor courts have ever provided any detailed rules on when a rental activity is a business. Now, the IRS has provided some additional guidance and a special safe harbor rule that can help many landlords.
Not every activity that earns money is a business for tax purposes. For any activity to be a business, you must engage in it regularly and continuously, primarily to earn a profit. A “sporadic” activity doesn’t qualify.
Virtually all landlords are trying to make a profit. However, by itself this isn’t enough for a rental activity to be a business. You must work at it regularly and continuously.
How much time must you put in for your rental activity to be a business? This has never been clearly defined by the IRS or courts. It is clear, however, that you don’t have to work full-time at it. Moreover, you don’t have to do all the work yourself. You can hire a manager or others to help you and still qualify as a business.
Landlords who own many rental units are almost certainly in business. But questions can arise where a landlord owns only a few units or only a single rental unit. For this reason, many tax professionals have been uncertain whether small landlords can claim the pass-through deduction. To help alleviate the uncertainty, the IRS has created a special safe harbor rule.
A “safe harbor” rule keeps taxpayers safe from the IRS. If you follow the rule, the IRS won’t bother you. The IRS is enacting a safe harbor rule for landlords solely for purposes of the pass-through deduction. If you follow the rule, the IRS will assume your rental activity is a business for purposes of the pass-through deduction—but for no other purpose.
You must satisfy three requirements to use the safe harbor:
If you have more than one residential rental property, you can combine them together for purposes of these requirements. However, you can’t combine residential with commercial properties.
You cannot use this safe harbor if you live in the property more than 14 days during the year, or more than 10% of the number the days during the year the property is rented.
Real estate rented or leased under a triple net lease is also not eligible for this safe harbor. Triple net leases require the tenant to pay for maintenance and insurance as well as rent. They are seldom used for residential real estate.
The 250 hour rental services requirement applies year-by-year for 2018 through 2022. For 2023 and later, you satisfy the requirement if 250 or more hours of services are performed in any three of five consecutive years ending with the current year. Real estate rental services include the following:
Such services don’t all have to be performed by you, the property owner. They may also be performed by your employees, agents, or independent contractors. For example, if you hire a real estate management company, the time they spend managing your property counts toward the 250 hour requirement.
The following types of activities do not count toward the 250 hours:
Starting in 2019, you must maintain contemporaneous time reports, logs, or other records, showing:
You don’t need to file these records with your tax return. Keep them available for inspection at the IRS’s request.
Since rental services performed by managers, agents, employees, and independent contractors count toward the 250 hour requirement, you should ask such workers to keep track of the time they work on your rentals.
This records requirement does not apply for the 2018 tax year, since the safe harbor was not created by the IRS until 2019. For your 2018 taxes, you should make your best estimate of the time spent performing rental services using the records you have. Ask rental managers and others who worked on your property to give you an estimate as well.
The rental pass-through deduction safe harbor is purely optional. You don’t have to use it if you don’t want to. Moreover, failure to satisfy its requirements does not mean your rental activity is not a business. For example, you don’t have to assume your rentals are not a business if you spend only 200 hours performing rental services during the year.
The safe harbor was created as a matter of convenience and to help tax professionals process the complex pass-through deduction. It does not establish absolute rules for how much work you must do for your rental activity to constitute a business for purposes of the deduction.
Whether any rental activity is a business is determined on a case-by-case basis based on the particular facts involved. Both the IRS and courts have found that ownership of even one rental property can constitute a business for tax purposes. However, the IRS and courts have also said that renting a single property (or more) doesn’t always constitute a business—it all depends on the facts and circumstances, including the day-to-day involvement of the owner or its agent.
If you worked less than 250 hours on your rentals during 2018, discuss with your tax professional whether you qualify for the pass-through deduction.