The passing of the 2017 Tax Cuts and Jobs Act has brought with it many ambiguities to an already overly complicated tax code. The addition of provisions related to Code Section 199A has only added ingredients to a hearty alphabet soup of IRS acronyms. Is my business a SSTB (specified trade or business)? What is my total QBI (qualified business income)? How do I calculate UBIA (unadjusted basis immediately after acquisition)? Even after fully digesting these new terms, clarity was still needed regarding rental properties. In response to multiple questions posed by taxpayers and practitioners alike, the IRS issued the final regulations and carved out a section that deals specifically with rental real estate.
The IRS issued final regulations related to Code Section 199A on Friday, January 18th, 2019. With those regulations came a few supporting IRS notices. One notice in particular, IRS Notice 2019-7, addresses safe harbors as they relate to rental real estate and Code Section 199A. Prior to the final regulations, there were questions as to what type of rental activity is eligible for the 20% deduction. Rentals under a “triple net” lease agreement, where the tenant is responsible for paying the real estate taxes, insurance, and maintenance on the property, were deemed to be ineligible for the deduction. However, taxpayers are asked to determine if their rental activity is a trade or business, as defined by Code Section 162, as a means to decide if it qualifies.
It is worth noting that the safe harbor provisions stated in IRS Notice 2019-7 only concern rentals as they relate to Code Section 199A. Therefore, the rules that govern whether or not a rental activity is passive under Code Section 469 are not affected. Also, the determination of a real estate professional under Code Section 469(c)(7) is a completely separate endeavor.
The Notice introduces a new term – rental real estate enterprise. It is defined as an “interest in real property held for the production of rents and may consist of an interest in multiple properties”. When it comes to meeting the safe harbor requirements, the IRS proposes that taxpayers take an “all or nothing” approach when addressing their multiple rental real estate enterprises. However, taxpayers are unable to group together residential and commercial real estate enterprises for purposes of this determination. Do keep in mind that this “grouping” of rental real estate enterprises as stated in IRS Notice 2019-7 is unrelated to any aggregation rules as described in Reg. Section 1.199A-4 of the final regulations.
Regarding the safe harbor requirements, IRS Notice 2019-7 lists the following three requirements that each rental real estate enterprise must have:
- Maintain separate books and records for each rental real estate enterprise;
- Perform 250 or more hours of rental services (with “rental services” defined below) per year for each rental enterprise [this pertains to taxable years beginning prior to January 1, 2023] OR perform 250 or more hours of rental services per year with respect to the rental real estate enterprise [this pertains to taxable years beginning after December 31, 2022, in any three of the five consecutive taxable years that end with the taxable year (or in each year for an enterprise held for less than five years)]; and
- Maintain contemporaneous records, including time reports, logs, or similar documents, regarding the following:
- hours of all services performed;
- description of all services performed;
- dates on which such services were performed; and
- who performed the services.
This pertains to taxable years beginning after December 31, 2018.
The second safe harbor above mentions the term “rental services”. The Notice states that rental services can be performed by either owners or by employees, agents, and/or independent contractors of the owners. Rental services can include:
- 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;
- management of the real estate;
- purchase of materials; and
- supervision of employees and independent contractors.
Therefore, any combination of the services listed above can be performed to meet the 250 hour test. To eliminate as much ambiguity as possible as it relates to what services qualify, the IRS does list a few services that do not qualify when attempting to meet the safe harbor requirement. Those activities include:
- financial or investment management activities, such as arranging financing;
- procuring property;
- studying and reviewing financial statements or reports on operations;
- planning, managing, or constructing long-term capital improvements; or
- hours spent traveling to and from the real estate.
It’s important to note that “triple net” lease agreements are not eligible for the safe harbor provision per the Notice. The Notice concludes by indicating that an attachment would need to be included for any taxpayer that is justifying that their rental activity is eligible for the QBI deduction by means of the safe harbor. The Notice states the language that should be used when completing the attachment. With any safe harbor, failure to meet the requirements listed above does not completely disqualify a rental activity from being eligible for the QBI deduction. A taxpayer’s specific facts and circumstances should be considered when deciding if the rental activity is a trade or business. For example, though the safe harbor requirements don’t explicitly state the need for preparation of Forms 1099, one can argue that a rental activity that does timely file these reports can be considered a trade or business. This is assuming that Forms 1099 are required to be issued. In summary, multiple factors may come into play when ultimately determining a rental activity’s eligibility for the 20% Code Section 199A deduction.
The rules relating to dealing with real estate and Code Section 199A can be arduous and complex. Feel free to reach out to a member of Withum’s Real Estate Team with questions concerning your particular situation.
Author:Andrew Murray, CPA, Real Estate Services Group Team Member | [email protected]
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