Tax Deductions and Real Estate Investors: Will You Get a 20% Deduction?
If you are involved in real estate investments, you need to understand how income from your property will be taxed.
While the 2018 tax reform law has created some positive changes for real estate investors, questions about taxes remain, including whether or not you can get a 20% deduction on real estate investments.
Is it Possible to Get 20% Tax Deductions on Real Estate Investments?
San Diego Purchase Loans is not a tax firm. This article is for general information only. Always speak with a qualified professional before making any investment or tax decisions.
If you own one or two residential properties, you may not qualify for the 20% federal deductions that are available to larger real estate investors and other “pass-through” entities. Unfortunately, it appears small real estate investors could miss out on the new tax deductions.
The federal tax law, which was passed in late December of 2017, allows many entities, including partnerships and sole proprietors, to deduct 20% of their qualified business income. Although it comes with specific limitations, this creates significant advantages for pass-throughs, which are businesses that basically pay no taxes and are instead taxed at personal rates for the owners.
This is an important provision, but it has raised a variety of complicated questions, including how an income for a rental will be treated by the IRS.
In August of 2018, the IRS proposed specific regulations for the pass-through provisions, but unfortunately these regulations won’t give many answers for real estate investors.
The deduction is available for any activity that is a “trade or business,” but this really has no clear definition within the tax law. The IRS will likely look to a specific section of the tax code for verification, probably citing areas that regulate deductible business expenses.
According to a 1986 Supreme Court decision, a taxpayer must be involved in the business and the primary purpose of the business must be financial gain. In other words, a hobby that happens to make money does not qualify.
However, the proposed regulations do not exactly clarify how many properties you need to own in order to qualify for the tax benefits, and it also doesn’t mention specific types. There is, however, one specific case that is mentioned: a business that owns property and rents to itself is allowed to treat that property as a business.
One area that is clear is that if you own shares in a real estate investment trust, you are allowed to deduct the 20% from your taxes. Investment trusts are considered pass-through entities, which allows them to qualify for the deduction.
Property you own directly is a little more complicated.
While tax professionals are still sorting the details, it seems clear that property rented on a triple net lease will not qualify for the 20% deduction. A triple net lease is an agreement in which the owner collects rent and the tenant is responsible for everything else included in the property, including maintenance, taxes, and home insurance. Beyond this type of lease, there is virtually no agreement on what qualifies and what does not.
Nothing is certain, but there appear to be some areas that have consistency. For example, if you own a 10-unit apartment building that needs regular maintenance and involves dealing with tenants, you will likely qualify, even if you hire a property manager to oversee the complex. Basically, if the work is preformed by a paid property manager and not a tenant, it would be the same as work performed by you under the tax code.
If you have at least five units in your ownership portfolio, you likely qualify for the deduction. However, if you rent out half of a duplex, it would probably not qualify. Also, if you rent out a single-family home that you inherited, you’ll probably won’t be able to use the deduction.
Even a single property that you rent out may qualify for the deduction, but you’ll have to talk with a tax professional to be certain. Half a duplex could qualify as a business, but you would likely need to demonstrate that it’s part of a continuing or regular business, which means you’d need to document hours and show what you’ve done on the property. However, a tax court judge may or may not disagree with you.
In some cases, even a five-unit building may not pass the test. There has to be significant work involved for it to qualify as a business, meaning daily maintenance conducted or paid for by the owner.
Tax professionals aren’t the only ones sorting the details. It appears that IRS officials are having just as much trouble trying to find the line. In many cases, IRS officials have not decided on how far they should extend the trade or business treatment to real estate rentals. This is nothing new, as real estate investments have always been difficult for the IRS. On one hand, it can be qualified as a business, but on the other, it may not require nearly as much hands-on effort as operating a restaurant or auto shop.
In other places of the tax code, the IRS has actually defined specific and quantifiable regulations for real estate. This includes definitions of real estate professionals and material participation. Whether they can provide this clarity to real estate investors has yet to be seen.
Tax professionals are hoping the IRS will incorporate rules that resemble previous definitions into their proposed regulations for the pass-through deduction of 20%. While the clarity has not been provided yet, it could come before the regulations are made official. This would be extremely helpful to the real estate market as a whole, as uncertainty can often be a road block to future investments.
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