Real Estate Safe Harbor for 199A
As discussed in our last post, on January 18, 2019, the Treasury Department issued final regulations governing the qualified business income deduction under §199A. In addition the IRS issued Notice 2019-7, which provides a safe harbor whereby a real estate activity will be treated as rising to the level of a trade or business, which is required for such an activity to be eligible for the §199A deduction.
This safe harbor provides a defined way for taxpayers and passthrough entities to show that a rental activity rises to the level of a trade or business. However, if a rental activity does not meet the safe harbor, it may still qualify as a trade or business, if it otherwise meets the requirements set forth in the Treasury Regulations (see Treas. Reg. §1.199A-1(b)(14)). (Considerations for whether a rental activity rises to the level of a trade or business are discussed on page 9 of the Tax Year 2018 M+O=CPE Individual Tax Year-End Workshop Reference Book.)
Under the safe harbor a rental real estate enterprise will be treated as a trade or business if all of following requirements are satisfied during the tax year:
Requirement 1: Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise.
Requirement 2: For taxable years beginning prior to January 1, 2023, 250 or more hours of rental services (discussed below) are performed per year with respect to the rental enterprise.
Note: For 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), 250 or more hours of rental services are performed (as described in this revenue procedure) per year with respect to the rental real estate enterprise.
Requirement 3: The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, regarding the following: (i) hours of all services performed; (ii) description of all services performed; (iii) dates on which such services were performed; and (iv) who performed the services. Such records are to be made available for inspection at the request of the IRS. The contemporaneous records requirement will not apply to taxable years beginning prior to January 1, 2019.
Definition of rental real estate enterprise: Solely for purposes of this safe harbor, a rental real estate enterprise is defined as an interest in real property held for the production of rents and may consist of an interest in multiple properties. The individual or passthrough entity must hold the interest directly or through an entity disregarded as an entity separate from its owner.
Taxpayers must either treat each property held for the production of rents as a separate enterprise or treat all similar properties held for the production of rents (with the exception of those described as not eligible for the safe harbor, as discussed below) as a single enterprise. Commercial and residential real estate may not be part of the same enterprise. Taxpayers may not vary this treatment from year-to-year unless there has been a significant change in facts and circumstances.
Definition of rental services: For the purpose of this safe harbor, rental services include: (i) advertising to rent or lease the real estate; (ii) negotiating and executing leases; (iii) verifying information contained in prospective tenant applications; (iv) collection of rent; (v) daily operation, maintenance, and repair of the property; (vi) management of the real estate; (vii) purchase of materials; and (viii) supervision of employees and independent contractors. Rental services may be performed by owners or by employees, agents, and/or independent contractors of the owners. The term rental services does not 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.
Return must include statement: A taxpayer or passthrough entity that uses this safe harbor must include a statement attached to the return on which it claims the section 199A deduction or passes through section 199A information that the requirements in Section 3.03 of the revenue procedure that is proposed in Notice 2019-7 have been satisfied. The statement must be signed by the taxpayer, or an authorized representative of an eligible taxpayer or passthrough entity, which states: “Under penalties of perjury, I (we) declare that I (we) have examined the statement, and, to the best of my (our) knowledge and belief, the statement contains all the relevant facts relating to the revenue procedure, and such facts are true, correct, and complete.” The individual or individuals who sign must have personal knowledge of the facts and circumstances related to the statement.
Safe harbor not available for certain real estate activities: The safe harbor is not available for real estate used by the taxpayer (including an owner or beneficiary of passthrough entity relying on this safe harbor) as a residence for any part of the year under Internal Revenue Code §280A. In addition, real estate rented or leased under a triple net lease is also not eligible for this safe harbor. For this purpose, a triple net lease includes a lease agreement that requires the tenant or lessee to pay taxes, fees, and insurance, and to be responsible for maintenance activities for a property in addition to rent and utilities. This includes a lease agreement that requires the tenant or lessee to pay a portion of the taxes, fees, and insurance, and to be responsible for maintenance activities allocable to the portion of the property rented by the tenant.
Taxpayers may rely on the safe harbor discussed until the IRS issues a final Revenue Procedure, which may change the safe harbor rule for future tax years.