by cdaaccounting | Jun 20, 2021 | Business Deductions
Nothing stays the same in the tax world, and that’s especially true with your 20 percent Section 199A tax deduction.
In January, an IRS Notice gave you a Section 199A safe-harbor option for your Coeur d’Alene rental properties, possibly making it easier for you to qualify for this new tax deduction. Now, the IRS has made a number of changes to its original notice and finalized the safe harbor in a Revenue Procedure. We note the changes below.
Big Picture on Rentals
Your rental activities qualify for the Section 199A deduction in one of three ways:
- They are a tax code Section 162 trade or Coeur d’Alene business.
- You rent them to a commonly controlled tax code Section 162 trade or business.
- They meet the Rev. Proc. 2019-38 safe harbor requirements.
Safe-Harbor Requirements
Under the safe harbor, and solely for Section 199A purposes, the IRS will treat your Coeur d’Alene rental real estate enterprise as a trade or business if you (or your pass-through entity) can satisfy the following three requirements:
- You maintain separate books and records that reflect the income and expenses of each rental real estate enterprise.
- You perform 250 or more hours of “rental services” during the tax year.
- You maintain 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.
Change #1. The “contemporaneous records” rule does not apply to tax years beginning before January 1, 2020—but don’t let this give you false hope. You still need proof.
Change #2. You can keep separate books and records for each property and later consolidate them to meet the record-keeping requirement.
Change #3. If the enterprise is in existence for at least four years, then you only need to meet the 250-hours test in any three of the five consecutive taxable years that end with the taxable year.
Change #4. The IRS clarified that use of the safe harbor is an annual determination.
Rental Real Estate Enterprise Requirements
To use the safe harbor, you arrange your rental activities into one or more rental real estate enterprises.
You have a choice. You can either
- treat each rental activity as its own enterprise, or
- put all commercial rental activities in one enterprise and all residential rental activities in one enterprise.
Change #5. You need to treat all the rental activities you place into a residential or commercial enterprise as a single trade or business for Section 199A purposes.
Change #6. You have two options for mixed-use properties. First, you can treat them as a single rental enterprise. Second, you can divide them into their component residential and commercial parts. You may not group multiple mixed-use rental activities into one mixed-use rental enterprise.
Ineligible Rentals
The following are not eligible for the safe harbor, and you can’t place them into an enterprise:
- Real estate you use as a residence under tax code Section 280A(d). Under this rule, your property is a personal residence if you use the property for personal purposes for a total number of days exceeding the greater of (a) 14 days or (b) 10 percent of the days you rented the property at fair market value.
- Real estate rented or leased under a triple net lease. For purposes of this safe harbor only, a triple net lease includes a lease agreement that requires the tenant or lessee to pay taxes, fees, and insurance, and to pay for maintenance activities for the property in addition to rent and utilities.
Change #7. For Section 199A purposes, real estate rented to a commonly controlled trade or business does not qualify for the safe harbor. You treat such a rental as being in the same business as the commonly controlled tenant.
Change #8. Real estate for which any portion is an out-of-favor specified service trade or business is not eligible for the safe harbor.
Disclosure
You or your pass-through entity must attach a statement to the tax return indicating that you are using the safe harbor and you satisfied the requirements set forth in Rev. Proc. 2019-38.
The statement has three required elements:
- A description (including the address and rental category) of all rental real estate properties you included in each rental real estate enterprise
- A description (including the address and rental category) of rental real estate properties acquired and disposed of during the taxable year
- A representation that the requirements of this revenue procedure have been satisfied
Change #9. You don’t have to sign the statement under penalty of perjury.
Clarifying Example
Sarah has four rental properties:
- Property A, a residential rental
- Property B, a commercial rental
- Property C, a commercial rental
- Property D, a mixed-use commercial and residential property
If Sarah wants to use the safe harbor, she can arrange her rentals in one of three configurations:
Configuration 1. Each property is its own enterprise. There are four enterprises:
- Property A
- Property B
- Property C
- Property D
Configuration 2. She combines the residential and commercial properties into their own enterprises and places the mixed-use property into its own enterprise. There are three enterprises:
- Property A
- Property B and Property C
- Property D
Configuration 3. She combines the residential and commercial properties into their own enterprises and bifurcates the mixed-use property. There are two enterprises:
- Property A and part of Property D
- Property B, Property C, and part of Property D
For all her rental activities to qualify for Section 199A under the safe harbor, Sarah will need to show
- 1,000 total hours of rental services in Configuration 1 (250 hours for each of the four enterprises);
- 750 total hours of rental services in Configuration 2 (250 hours for each of the three enterprises); and
- 500 total hours of rental services in Configuration 3 (250 hours for each of the two enterprises).
Final Thoughts
The good news with the safe harbor is that it gives you a guaranteed way to ensure that your rentals qualify for the Section 199A deduction.
The bad news is that you may not meet the requirements to qualify for the safe harbor.
by cdaaccounting | Jun 7, 2021 | Business Deductions
It’s common to consider making your S corporation (versus yourself) a partner in your partnership: it saves you self-employment taxes.
Does this affect your Section 199A deduction? It does.
Guaranteed payments are not qualified Idaho business income (QBI) for the Section 199A deduction.
The non-QBI guaranteed payment rule applies whether the partner receives the payment as an individual or as pass-through income from an S corporation.
Your only options to claw back your Section 199A deduction with the S corporation as a partner are to
- reduce or eliminate the partnership’s guaranteed payments, and take the income pro rata based on ownership percentage; or
- use a special allocation of partnership tax items.
Keep the Coeur d’Alene S corporation self-employment tax savings in mind when considering your partnership activity. Often the savings can make the S-corporation-as-a-partner strategy well worth it.
by cdaaccounting | May 21, 2021 | Business Deductions
It’s common to consider making your Idaho S corporation (versus yourself) a partner in your partnership: it saves you self-employment taxes.
Does this affect your Section 199A deduction? It does.
Guaranteed payments are not qualified Coeur d’Alene Idaho business income (QBI) for the Section 199A deduction.
The non-QBI guaranteed payment rule applies whether the partner receives the payment as an individual or as pass-through income from a Coeur d’Alene Idaho S corporation.
Your only options to claw back your Section 199A deduction with the S corporation as a partner are to
- reduce or eliminate the partnership’s guaranteed payments, and take the income pro rata based on ownership percentage; or
- use a special allocation of partnership tax items.
Keep the Coeur d’Alene Idaho S corporation self-employment tax savings in mind when considering your partnership activity. Often the savings can make the S-corporation-as-a-partner strategy well worth it.
by cdaaccounting | May 16, 2021 | Business Deductions
Now, add to this no-tax-on-sale benefit to the 21 percent corporate tax rate from the Tax Cuts and Jobs Act, and you have a significant tax planning opportunity.
Imagine this: You sell your Idaho C corporation. The sale produces a $6 million capital gain to you.
Your federal income tax bite on the $6 million of gain is zero. Yes, you are awake. You are reading this correctly. The tax bite is zero.
Internal Revenue Code Section 1202 establishes the rules for the zero tax bite. To get to zero, you need to operate your business as a tax code-defined QSBC.
You may already have a tax code-defined small business corporation in Coeur d’Alene Idaho, or you may be thinking of starting a new Coeur d’Alene business as a small business corporation. Paying zero taxes on the sale of your business stock is a big incentive.
100 Percent Gain Exclusion Break (Tax-Free Capital Gains)
To qualify for tax-free capital gains, you must acquire your QSBC stock after September 27, 2010.
More Than Five Years
Of course, there’s more than one rule. You must hold your QSBC stock for more than five years to qualify for the tax-free treatment.
Limitations on Excludable Gains
Your beloved lawmakers impose limits on your tax-free capital gains from the sale of a particular QSBC. In any taxable year, the tax limits on your eligible gain exclusion may not exceed the greater of
- 10 times the aggregate adjusted basis in the QSBC stock you sell, or
- $10 million reduced by the amount of eligible gains that you’ve already taken into account in prior tax years from sales of this QSBC stock ($5 million if you use married filing separate status).
Example 1: $10 Million Limitation
You are a married joint filer. You invested $100,000 when you started your C corporation in 2012.
Now, in 2019 (more than five years after the start), you sell the stock in the C corporation for $6.1 million. You have tax-free capital gains equal to the greater of
- $1 million (10 x $100,000), or
- $6 million (because it’s less than $10 million).
You have $6 million of tax-free capital gains.
Example 2: 10-Times-the-Basis Limitation
You are an unmarried individual. You invest $2 million in a single QSBC stock this year.
In 2025, more than five years from now, you sell this stock for $24 million, resulting in a total gain of $22 million ($24 million – $2 million). The tax code limits your tax-free gain to the greater of
- $20 million (10 times the basis of the stock), or
- $10 million.
In 2025, you have $20 million in tax-free capital gains and $2 million in taxable capital gains. You have to be smiling.
Definition of QSBC Stock
To be eligible for the QSBC gain exclusion, the stock you acquire must meet the requirements set forth in Section 1202 of our beloved Internal Revenue Code. Those requirements include the following:
- You generally must acquire the stock upon original issuance or through gift or inheritance.
- You must acquire the stock in exchange for money, other property (not including stock), or services.
- The corporation must be a QSBC at the date of the stock issuance and during substantially all the period you hold the stock.
Next, you have to look at the rules that apply to the corporation. To qualify as a QSBC, the following rules apply.
Rules for the Corporation
Your Coeur d’Alene corporation must be a domestic C corporation.
The corporation must satisfy an active business requirement. That requirement is deemed satisfied if at least 80 percent (by value) of the corporation’s assets are used in the active conduct of a qualified business.
Beware. Qualified businesses do not include
- the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any other business where the principal asset is the reputation or skill of one or more of its employees;
- banking, insurance, leasing, financing, investing, or similar activities;
- farming (including raising or harvesting timber);
- production or extraction of oil, natural gas, or other natural resources for which percentage depletion deductions are allowed; or
- the operation of a hotel, motel, restaurant, or similar business.
The Coeur d’Alene corporation’s gross assets cannot exceed $50 million before the stock is issued and immediately after the stock is issued (which considers amounts received for the stock).
by cdaaccounting | May 1, 2021 | Business Deductions
Here’s an easy example to illustrate.
Let’s say that in 2017, you purchased for Coeur d’Alene business use a pickup truck with a gross vehicle weight rating greater than 6,000 pounds. Asserting that you use the pickup 100 percent for business, you expensed the entire $55,000 cost.
What happens to that $55,000 expensed amount if you die, retire, or become disabled before the end of the vehicle’s five-year depreciation period?
Death
If your heirs are not going to pay estate taxes, your death is about as good as it gets. Here’s why:
- You get to keep your Section 179 deduction. (It goes to the grave with you.)
- Your pickup truck gets marked up to fair market value. (Remember, you expensed it to zero, but now at your death, the fair market value is the new basis to your heir or heirs.)
Example. Using Section 179, you expensed the entire cost of your $55,000 pickup truck. You die. Your daughter Amy inherits the pickup at its fair market value, which is now $31,000, and sells it immediately for $31,000. Here are the results:
- You get to keep your Section 179 deduction—no recapture applies.
- Amy pays zero tax on her sale of the pickup truck.
- Your estate includes the $31,000 fair market value of the pickup, and if your estate is less than $11.4 million, your estate pays no estate taxes.
Disability
This is ugly. If you become disabled and you allow your Coeur d’Alene business use of the pickup to fall to 50 percent or below during its five-year depreciable life, you must recapture and pay taxes on the excess deductions generated by the Section 179 deduction.
To make matters worse, you must use straight-line depreciation in making the excess-deduction calculation.
Retirement
With retirement, you have exactly the same problem as you would have if you became disabled. In fact, with retirement, you disable your Coeur d’Alene business involvement, and that makes your pickup truck fail the more-than-50-percent-business-use test, resulting in recapture of the excess benefit over straight-line depreciation.
Takeaways
You need to consider what happens should you become disabled, or retire, or die.