Tax Planning for 2021’s Schedule E of Form 1040

August 3, 2021

By Michael Pusey, AccountingWEB

The IRS’s initial draft of 2021’s Schedule E components are often major elements of tax liability or savings, and often the most complex details of the return.

The parts consist of rental real estate and royalties, income of partnerships and S corporations, then income of trusts and estates, followed by a section on REMICs (real estate mortgage investment conduits). The fifth and final section sums these parts, also adding a “one-liner” (line 40) for net farm rental income from Form 4835.

These are summed and carried to another portion of the return. This is then followed by two reconciliation sections, one dealing with farming and fishing, and the other real estate professionals. There is also the possibility of later drafts.

IRS policy is that the last of the drafts reflects the final form. Some IRS forms have significant narrative instructions following the text of the form, but that’s not the case with Form E. The total of Schedule E will flow to the 2021 Form 1040 Schedule 1 (Draft of July 21, 2021. Text is found at https://www.irs.gov/pub/irs-dft/f1040s1--dft.pdf).

The 2020 Schedule E came with 12 pages of separate instructions. These aren’t out for the 2021 form as we write in late July. For example, the 2020 instructions tell the beneficiary of an estate or trust to file Form 8082 if reporting differently than the trust or estate return. The same form may need to be filed when there is a similar disparity in the entity return and the flow-through income reported by partners or S corporation shareholders.

Rental real estate income or loss may reach one’s return via the section of Part I dealing with rental real estate. It may also begin with Form 8825 required of partnerships and S corporations, then reach the Form 1040 by way of flow-through via Part II of Schedule E.

There are two versions of the K-1, one reporting flow-through for partnerships and another for S corporations. The 2021 drafts of these schedules aren’t published as of this writing (K-1, Form 1120S, and K-1, Form 1065. See “About Schedule K-1 (Form 1120S), Shareholder’s Share of Income, Deductions, Credits, etc.,” https://www.irs.gov/forms-pubs/about-schedule-k-1-form-1120-s; and “About Schedule K-1 (Form 1065), Partner’s Share of Income, Deductions, Credits, etc.”, https://www.irs.gov/forms-pubs/about-schedule-k-1-form-1065).

There is an IRS web site that focuses on the Schedule E which, while light on commentary, provides a list of related forms and IRS sites or publications. This “roadmap” of possible areas of importance can be quite helpful (“About Schedule E (Form 1040), Supplemental Income or Loss,” https://www.irs.gov/forms-pubs/about-schedule-e-form-1040).

Our remaining discussion will focus on some of the more important tax rule details affecting the form, with some mention of possible law changes. New realty acquisitions entail issues including analysis of closing statements to resolve what is capital in nature.

For example, title closing costs and brokerage commissions enter into total basis, which then looks to the allocation between depreciable building and land. Studies may also break-down building costs into components having shorter depreciable lives.

The cost allocation turns on the relative values of the building and the land. This determination is commonly resolved by relative values in the tax assessment. In planning one’s time, much of this work can be done prior to the tax professional having year-end figures.

It is possible that the level of services provided in connection with rentals, such as maid service, will move the rentals from Schedule E to Schedule C, the business schedule. There are circumstances in which realty rentals may be subject to the self-employment tax, which may cost but eventually yield higher social security benefits.

There are also circumstances in which realty rentals may be subject to the 20 percent of business income deduction under Section 199A (See Notice 2019-07; IRS Pub. 527, “Residential Rental Property (Including Rental of Vacation Homes"). For use in preparing 2020 returns see p. 12-14; “Rental property and the qualified business income deduction,” Breedlove, The Tax Institute, thetaxinstitute.com, 9/9/19).

Higher income taxpayers may be subject to the 3.8 percent net investment income tax (Sec. 1411). Rental income, gains from rental realty and other types of Schedule E income may be subject to this tax, and so can affect the year-end planning (See Form 8960). The 2021 draft version of Form 8960 is not out as of this writing.

The benefit of the employee retention credit may come with some complex disallowance aspects as to wages and payroll tax. These can impact the results on Schedule E. The employee retention credit is easily overlooked but it can be important in 2021’s year-end planning.

It can also impact such decisions as whether to maximize other tax deductions. The topic is impacted by three sets of legislation, only the last of which actually made it into the Internal Revenue Code as Section 3134, which is effective only for a particular period that isn’t even an entire year.

So, the tax professional may have to deal with the CARES Act, Taxpayer Certainty and Disaster Relief Act, and the American Rescue Plan Act in resolving issues important to Schedule E.

There are IRS pronouncements but no regulations, not even proposed regulations, on the employee retention credit (See “COVID-19-Related Employee Retention Credits: Special Issues for Employers FAQs,” #85 re wage reduction; https://www.irs.gov/newsroom/covid-19-related-employee-retention-credits.... The latest pronouncements on this topic include IRS Notices 2021-20, 2021-23, 2021-24).

There is a President Biden (or Biden-camp) proposal aimed at certain partners and S shareholders not paying either the self-employment tax or the Section 1411 3.8 percent tax. The effective date of the proposal is taxable years beginning after December 31, 2021, so as currently drafted, these provisions may not impact our current year, 2021.

Any legislative changes here may not impact Schedule E even if focusing on those primarily concerned with Schedule E. Such provisions, if passed into law, may eventually affect such details as the reporting of self-employment income on the Form 1065 K-1 and the Form 1040, Schedule SE.

Final Review

So, in reviewing Schedule E issues, keep in mind there may be important partnership and S corporation elements flowing to Schedule SE and Form 8960 (See “Proposed Changes to Self-Employment Tax Rules,” Pusey, accountingweb.com, 6/14/21, https://www.accountingweb.com/tax/business-tax/proposed-changes-to-self-... also “Self-Employment Tax Planning for2021,” Pusey, accountingweb.com, 10/23/20, https://www.accountingweb.com/tax/individuals/self-employment-tax-planni...).

In general, some of the more important questions that should be reviewed with the client arise from the practitioner’s review of the details of Schedule E.

This article originally appeared on AccountingWEB.com.

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