As part of the Tax Cuts and Jobs Act (TCJA), a new 20% tax deduction was created for the qualifying business income of partnerships, S corporations and sole proprietors. This is known as the Section 199A deduction. At the time of its passing, it was unclear when a rental real estate activity would rise to the level of a “trade or business” and qualify for this tax break. On Friday, January 18th, the IRS released Notice 2019-07 which includes a proposed revenue procedure to provide real estate investors with a safe harbor test to allow for their rental activities to be considered a trade or business and qualify for the 199A deduction.
The proposed revenue procedure focuses on when a “rental real estate enterprise” (enterprise) will be considered as a “trade or business” under the safe harbor rules solely for purposes of the Section 199A deduction and not be challenged by the IRS. An enterprise is defined to be an interest in real property held for the production of rents owned by an individual or “relevant passthrough entity” (RPE) which may consist of an interest in multiple properties. An RPE is defined to be a partnership (other than a PTP) or an S corporation that is owned, directly or indirectly, by at least one individual, estate, or trust. The safe harbor test only applies to those interests held directly by the individual/RPE or through a disregarded entity. Taxpayers may treat each rental activity as a separate enterprise or may treat all similar properties as a single enterprise. Commercial and residential rental real estate cannot be part of the same rental real estate enterprise as they are not deemed to be similar properties.
A quick example may help to illustrate these enterprise rules more clearly. An individual taxpayer owns five rental properties directly. Three of the properties are residential and two are commercial. This taxpayer has the option to treat each of the three residential properties as either a single enterprise or as three separate enterprises for purposes of the safe harbor test. Additionally, this taxpayer has the option to treat the two commercial rentals as either the same or separate enterprises. Once the taxpayer decides whether to treat their rental activities as a single or separate enterprise, they must continue to treat them in the same manner going forward.
The safe harbor test provides that an enterprise will be treated as a trade or business for Section 199A if it meets the following criteria:
- Separate books and records are maintained for each enterprise;
- 250 hours of rental services are performed during the year with respect to the enterprise; and
- The taxpayer maintains records, including time reports and logs, to support the hours, dates, description and provider of the services performed.
Qualifying rental services for the 250 hour criteria include advertising, negotiating and executing leases, information verifications, rent collections, daily operation, maintenance and repair of the property, management of the real estate, purchasing of materials, and supervision of employees and independent contractors. These rental services may be performed by owners or by employees, agents, and/or independent contractors of the owners of the enterprise. Excluded from rental services are financial or investment management activities, planning, managing, or constructing long-term capital improvements, or hours spent traveling to and from the real estate.
The proposed revenue procedure does exclude certain rental activities from utilizing the safe harbor test. Real estate used by the taxpayer as a residence for any part of the year such as a vacation home which is also rented when the owner isn’t using it does not qualify. Additionally, real estate rented under a triple net lease is not eligible to use the safe harbor. The proposed revenue procedure defines a triple net lease to be a lease agreement that requires the tenant or lessee to pay taxes, fees and insurance, and to be responsible for the maintenance activities for a property in addition to rent and utilities.
It’s also important to note that a taxpayer not qualifying for the safe harbor test may still be able to have their rental activities qualify as a trade or business for purposes of the Section 199A deduction. The trade or business determination will be made based on the individual facts and circumstances of a taxpayer’s rental activities. Unfortunately, taxpayers who will find the safe harbor test difficult to satisfy will not have a bright-line test to utilize as the facts and circumstances determination is subjective and could be challenged by the IRS upon examination.