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Business tax ‘safe harbor’ not such a safe bet

Jim HamillALBUQUERQUE, N.M. — The hot issue in the 2018 tax season is the new 20 percent deduction for “qualified business income.” I have written about this, most recently about whether it applies to rental income.

Last month’s final regulations resolve some uncertainty, but a rental property as a business seems to be a particular sticking point with the IRS. Whether a rental can be a business affects several tax breaks.

First, if the rental is sold at a loss, business classification allows that loss to be deducted without any limits. If the rental is an investment, the loss is a capital loss and is limited to offset capital gains or to offset other income only up to $3,000 each year.

Second, if income is high enough, a 3.8 percent surtax can apply to the rental income classified as investment income. If it is business income, taxpayers classified as “qualified real estate professionals” may be able to avoid this 3.8 percent investment surtax.

Third, the 20 percent qualified business income deduction is available if the rental is a business. It is lost if the rental is an investment.

It is not surprising that the IRS has suggested that most rentals are not businesses. In particular IRS challenges that a single rental property, such as a house or a condo, can be a business.

The Tax Court, right or wrong, has almost always come down on the side that a single rental property can be a business. Some reasonable tax advisers find that conclusion a too expansive definition of a business. But as an advocate of a client, tax advisers should surrender to the wisdom of the court.

The IRS, it seems, continues to fight. That’s fine. Reasonable people can disagree on many tax questions. But I do believe there is an obligation to be reasonable. And the IRS just issued some procedural guidance that fails the reasonableness test.

This guidance applies only to the 20 percent business income deduction. And only to income from a rental. It is referred to as a “safe harbor,” meaning that if one stays in the harbor no harm comes to you. If you leave the harbor, perhaps you survive, perhaps not.

Generally we welcome safe harbors. A taxpayer may choose to putter around the harbor or venture into the open seas. But choice is good.

The IRS will not challenge you if you meet the requirements of the harbor. But if those requirements are just silly – that is, if it were impossible to reasonably challenge anyone meeting the requirements, the harbor provides no meaningful protection.

And an unreasonable safe harbor can bring harm when IRS agents look at it as more than it is. That is, if they look at a failure to satisfy the harbor as evidence of a ripe target for attack, unreasonable safe harbors actually hurt taxpayers in general.

The Tax Court has not required any significant effort on the taxpayer’s part to find a rental to be a business. The IRS explanation of the safe harbor ignores all of these cases.

A single rental house would require little time investment. The safe harbor says the taxpayer must spend 250 hours during the year on rentals. There can be no personal use of the rental property. The property cannot be rented under a triple net lease.

The taxpayer must have a contemporaneous record of hours spent. The Tax Court has never required anything like this.

Anyone meeting these tests will absolutely have a business under the Tax Court’s analysis. No question. So a “safe” harbor is meaningless to such a person. It offers protection from nothing. But it can imply that failure to meet the tests means the rental is not a business.

The safe harbor says – not so. Failure to meet the safety rules does not means you are injured. But I am talking about real people and how they will approach this.

To take advantage of the safe harbor, you must attach a statement to your return providing all information to prove your eligibility, and sign under penalties of perjury.

Most regulatory and procedural safe harbors in the tax law are welcome. This one is not. It provides no meaningful relief and imposes unnecessary and unreasonable conditions on the taxpayer.

Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at