Welcome to the Bryn Mawr Trust Wealth Management Podcast, providing commentary on what’s moving the financial markets, financial planning, and other timely business and monetary topics. Please welcome your host, Jennifer Fox, President of BMT Wealth Management.
[JENNIFER FOX] Welcome to everyone. Welcome to our podcast. A few weeks ago at Bryn Mawr Trust, we hosted an educational seminar for our clients on the 2017 Tax Cuts and Jobs Act, the new 199A section of the tax code. That’s where I met today’s guest, Tony Lopes, an attorney with Riley, Riper, Hollin & Colagreco, Attorneys at Law. So Tony counsels business owners and entrepreneurs on federal and state tax matters, which is the topic of our conversation today. And Tony was our guest presenter at the seminar that we had and did a fantastic job. Really excited to have him with us, because we got some of the best feedback ever on that presentation.
[TONY LOPES] Oh, thank you so much for saying that.
[JENNIFER FOX] And we’ve been doing these for 10 years, so–
[TONY LOPES] Wow.
[JENNIFER FOX] No pressure today, Tony. No pressure whatsoever. So welcome, and looking forward to our conversation.
[TONY LOPES] Yeah. Thank you so much for having me. And I hope that all your listeners are strapped in, because we are in for a bumpy ride. Section 199A can be a little complex to deal with. So initially, the first thing to say is make sure, despite this podcast, to go come to BMT, talk to Jen, talk to your financial advisors, and then also, bring in your accountants and attorneys to help you out with this very complex provision of the tax code.
[JENNIFER FOX] Yeah. And thank you for touching on that, because it is complex. I’ve had the opportunity to be at your presentation, read through, in detail, a lot of the deck. And I will be candid– there is so much information. And depending on your specific fact pattern, it can really take you down a different avenue of this section.
I think one provision– there’s a lot of them, but the one that we wanted to focus on today was really around real estate investors. So I know especially in the greater Philadelphia area, when we think of our client base that we have, we have a lot of folks who really value investing in real estate and will likely have a lot of questions about how does this provision help the real estate investor.
[TONY LOPES] Correct. So essentially, you need to look at the operational rules, which are part of the regs at section 1.199A-1. That’s where you can find the operational rules. And you can just google that. They’ll pop up. Again, you’re not doing your own planning. Work with your trusted advisors. But this is so you can educate yourself and see strategically where you’re going to fall before you have those discussions.
So first and foremost, we have to look at real estate businesses and whether or not they’re going to be qualified as a trader business to begin with, not just a passive activity. So notice 2019-7 provides a safe harbor for rental real estate enterprises to qualify as trades or businesses. And it goes back to section 162. It’s the classic– the IRS is making it a little complex, what is a trader business, what isn’t. But there are ways that you can confirm that you’re going to meet certain tests. And we’ll get into that in a quick second.
But the good news is that interest in real property held for rent can qualify for this deduction. So that’s good. And you can have entities that are either individual entities that each are associated with one real estate property, or you can have entities that consist of multiple properties. Now, here’s that caveat where the IRS and the Treasury said we’re not going to let you change that from year to year. And thus, you have a significant reason to do so. So some substantial change, some significant change in the circumstances. And it’s going to be a facts or circumstances kind of test. So don’t think that you’re going to be able to game the system by flipping entities and having properties move from one entity to the other.
So what is excluded is real estate used as a resident by the taxpayer. And that’s from Internal Revenue Code section 280A. And then real estate rented or leased under a triple net lease. Unfortunately, in the proposed regs, the IRS and the Treasury were considering allowing for triple net leases if I recall correctly. But when the final regs came out, they made the decision not to.
[JENNIFER FOX] Got it. Got it. So in this case– So. If we go back to treating each property as in enterprise– so if that would be that you purchase a rental property, you put it in the LLC, that you can’t move that property from one entity to the next or exchange it from one entity to the next? You’d have to keep the treatment the same?
[TONY LOPES] Correct. And you can’t mix residential and commercial. That’s another important thing to look at. So you have to be cautious there. But you really need to strategically plan all this out. And if it makes more sense to have the entity structured in a particular way that’s going to be beneficial to you, great. But remember that your QBI is going to aggregate anyways. So you can’t have one entity that’s dumping a bunch of losses, and you’re going to ignore it. Those losses are going to affect your deduction overall. So you need to look at the big picture as well as– the forest and the trees, if you will, for lack of a better term.
[JENNIFER FOX] Got it. Got it. So that makes– I think that that helps to clarify in terms of entity planning for real estate, that you have to look at both as you’re starting to plan for that the deduction.
[TONY LOPES] Right.
[JENNIFER FOX] OK.
[TONY LOPES] And then we can look at the safe harbor requirements so that we strategically plan how we’re going to do this. So how are we going to qualify this rental real estate enterprise as a trader business so that you can apply this deduction? So what you need to do is, first and foremost, you need to keep separate books and records. You need to maintain separate books and records which show income and expenses for each rental real estate enterprise. That’s a mouthful. And the taxpayer needs to maintain contemporaneous records, time reports, logs, or similar documents regarding hours of all of the services that are performed, a description of those services, dates on which those services were performed, an d who performed those services. So you have to be very diligent about your bookkeeping in order to qualify.
[JENNIFER FOX] We talk about real estate used as a residence by the taxpayer, but what about a vacation home? So I’m thinking of summer is coming up pretty quickly. There’s a lot of folks who own shore homes and rent them out for a bulk of the summer, staying within those rental rules. How would that fall into this tax benefit, perhaps?
[TONY LOPES] So it’s going to be a facts and circumstances analysis. And I hate to be the lawyer in the room and give you the grayest answer possible. But basically, it’s true. There’s no other way to look at it. You really have to look at whether that property is a business or you’re just trying to game the system.
And if we’re talking about a property that is a legitimate rental, that is a business, you can look at those safe harbor requirements, and see where it fits in some of those examples, and look back at those Treasury regs to see where it fits. Now, to the people listening, I’ll warn you now– unless you’re having trouble sleeping, those regs are going to be very difficult to look at and to parse through. They’re huge, several hundred pages. So again, go talk to BMT. Ask them to take a look at your assets for you.
[JENNIFER FOX] Yeah, definitely dense reading with a lot of backtracking. But I do think– again, on the vacation home part of that, especially with rental properties that we have at the shore or in the mountains, I think that’s something that would be at a common question. I might not be a real estate investor like some of our major real estate investor clients, but I do have a property that I receive income on. So it is something to look into and go through those facts and circumstances with advisors.
[TONY LOPES] Correct. So as part of the safe harbor requirements, we’ll talk a little bit more about how you can get there. So one of the other things that’s in the safe harbor requirements are that you have to have 250 or more hours of rental services which are performed with respect to the rental enterprise. So that kind of answers your question. That’s sort of a bright line. Where are we above that 250, or not?
[JENNIFER FOX] OK. I have to ask that. So the 250 or more hours of rental services– what is rental services?
[TONY LOPES] Glad you asked. So in those safe harbor requirements, they do list out what’s included and what’s not included. And the IRS and the Treasury, again, gave a little and kind of took a lot. So we need to be careful there. But rental services that are included that will get you to the 250 hours are advertising to rent or lease the real estate, negotiating and executing leases, verifying information contained in prospective tenant applications, collection of rent, daily operation, maintenance, and repair of the property. That one is thankfully a no-brainer. Purchase of materials to maintain the property, supervision of employees and independent contractors. But take note that rental services can be performed also by your employees, agents, and/or independent contractor. So that’s great. You can hire people to run your property for you. And as long as you’re getting above the 250 hours with items from that list, you’re going to be in good shape.
Again, going back to the beginning of this discussion, you really need to keep solid books. You need to have those hours of the services that are performed, descriptions, dates, and who performed the services. You really want to create a back record so that you can make a solid argument if you do get audited or have some issues.
[JENNIFER FOX] Yeah. Because I’m thinking of 250 hours is a good 6 and 1/2 weeks of 40-hour workweeks. So being able to document that from especially independent contractors and things like that, that can start to add up to that 6 and 1/2 weeks, roughly, of hours.
[TONY LOPES] Right. If you have a legitimate property– it’s tough with a shore house. So if you have one shore house, and that’s your real estate rental enterprise, you’re going to be hard pressed to get that 250. It’s going to be tough.
[JENNIFER FOX] That’s a lot of landscaping.
[TONY LOPES] Yeah. You better have a topiary garden, right? But you can get there theoretically, but it’s an active business. That’s essentially what we’re looking at. As you said, 250 hours is up there. It’s beyond six months of 40-hour work weeks for one individual.
Now, when you’re spreading it across maintenance people, housekeeping, as you said, landscaping, those kinds of maintenance and repair individuals, maybe it can get there. So you can plan strategically to get there as well. Now, the rental services that are not included, so what doesn’t get you to the 250 hours, are financial or investment management activities, which kind of sucks, procuring property, studying or reviewing the financial statements or reports on operations. Again, this is where I think the IRS and the Treasury were a bit harsh. Because to me, that’s a pretty active part of running a businesses, is looking over your books and seeing whether or not you’re strategically investing the property appropriately or managing your rental activities appropriately. And then time spent traveling to and from the property is not going to get you there.
However, if you look at a little nuance there, we’re talking about travel to and from the property, not travel once you’ve gotten to the property and have to run to the hardware store or have to meet with people off site to organize maintenance. So you can get strategic with this. Look between the lines. Work with your financial planner. Be careful, and you can get there if you work strategically enough.
Now, one other thing that we need to note is that under the safe harbor requirements, you’re going to have to include a statement on the return, under penalties of perjury, that the requirements for the safe harbor are satisfied. That’s a little bit of a tough hurdle to jump over also if you’ve really been playing with a lot of these things. So be careful.
[JENNIFER FOX] Got it. And I look at– when we always look at tax planning opportunities and things like that, there’s levels of aggressiveness. And I would say in this case, being able to be really clear about what you’re doing, and being very clear with your advisors, and getting that good advice, is especially critical, especially with that statement on the return, which is a pretty new requirement.
[TONY LOPES] Yes, that’s correct. And it’s a tough one. I wouldn’t want to be subject that if I were not appropriately documenting everything. So that’s why those books and your records are going to be so important to make sure that you’re keeping a solid track record of what you’re doing. And then we can take a look, as your trusted advisors, and look at what you’ve done over the course of the year, and see if we can get you there, and work strategically for the future as well. But you need to be careful.
[JENNIFER FOX] So let me ask you a different question when it comes to real estate. Because with real estate, the whole passive active is a critical part in tax planning. So how does passive– how does that factor in to the conversation of whether it’s passive losses or active losses when you’re trying to aggregate from the tax benefit?
[TONY LOPES] So in theory, section 199A is generally thought of as its own provision separate from all others– not meaning that, of course, you don’t look at the overall picture looking at passive and active business activity. But for purposes of section 199A, that is not a consideration. So if you get above the 250 hours– although as we were discussing, if you’re getting above these 250 hours, you’re most likely in an active business situation anyway. But there might be a situation, of course, that’s a passive activity that does go above the 250, so you still might be able to get your QBI deduction.
[JENNIFER FOX] So as I’m thinking of this visually– and I know this is a podcast, so you can’t see it, but–
[TONY LOPES] She’s drawing on the board right now as we speak.
[JENNIFER FOX] But as I think about it from a visual perspective, so it’s almost as if you do your entire tax return as if you had done it in years prior, 2018, and then section 199A comes on top of that as a calculation for a potential deduction on business that’s already calculated with some specific provisions on how that works. But it’s an additive calculation.
[TONY LOPES] Correct. And I’m glad you brought that up, because actually, we should also discuss the fact that there is a sunset provision. So the Tax Cuts and Jobs Act itself is set to expire by 2025. And so what will happen is it only runs for years 2018 to 2025, and in 2026, theoretically, is when it will expire, because it will apply to the year 2025. So your planning is not super long term here. So that’s also, as you said, not the tax tail wagging the dog.
You need to do some immediate planning. And there are some reasons to– even for your estate planning, which we’ll talk about on another episode, I’m sure. But you need to think about all of these things and maximize what you can now while also not affecting your longtime strategy too drastically.
[JENNIFER FOX] I think that’s a great point, especially on the sunset provisions of that. Because the only way that this would be extended is if there was another congressional action to extend the provisions. Correct?
[TONY LOPES] Right, correct. So there’s a lot of also presidential risk. We are on the cusp of another presidential election sooner or later. And depending on what happens with that, this could all change also. It won’t change overnight. Changing tax provisions– by the way, the most exciting time to be a tax attorney or involved in tax in some capacity– we have a lot to talk about. But it won’t change overnight, certainly even if there is a change in political climate. But it could change. So even as soon as 2020, 2021, 2022, things could change.
Is it worth it for the IRS and the government to really make those drastic changes? Probably not. Maybe we will ride this out to 2025, but we don’t know. So maximize now. Look at the– again, not for this podcast episode, but also look at the trust and estates. Your unified credit is very worthwhile right now, so a good time to go and talk to your trust and estates attorney as well. A little bit of self-serving, I guess, but–
[JENNIFER FOX] Well, it goes to the old adage– the only thing that’s certain is death and taxes. And in this case, we know the taxes are certain, but the deductions are not. So it’s something that makes a lot of sense to take a look at.
[TONY LOPES] Yeah. And the IRS has been pretty good, also, about stating pretty clearly that they’re going to honor the current tax regime while it’s active. So now is the time to maximize your unified credit. Now’s the time to maximize these QBI deductions while you can. But again, as you said, don’t allow this to change your overall strategy so drastically that if there is a change to the law, even before 2025, that now you’re in a pickle, so to speak, because you have to readjust and go back to your old ways of preparing and doing your financial planning.
[JENNIFER FOX] Tony, great advice. Thank you so much for joining me today.
[TONY LOPES] Well, thank you for having me. This was fantastic.
[JENNIFER FOX] And I appreciate all of the insight on 199A. I definitely feel like I have another level of clarity around a very detailed tax regulation. But thank you.
[TONY LOPES] No problem. Thank you very much for having me. This was great.
[AUDIO CONCLUSION/CLOSE] This has been a production of Bryn Mawr Trust, copyright 2019. Visit us online at bmt.com/wealth.
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