IRS Clarifies 199A Section of Tax Law, Provides Safe Harbor and a 20% Deduction To Rental Real Estate Enterprises
If you own rental real estate, the fact that the IRS just issued Notice 2019-7, which clarifies Section 199A of the Tax Cuts and Jobs Act of 2017 could work to your benefit. The clarification will help in determining whether a rental real estate enterprise is a trade or business for the purposes of section 199A. From the outset, Section 199A sought to extend benefits of the Tax Cuts and Jobs Act to small businesses. It provided individuals and flow-through entity owned “trades or businesses” a 20% deduction of the taxpayer’s qualified business income. The unanswered question was:
Can rental real estate qualify as a “trade or business?” On January 18, 2019, the IRS answered: “Yes, it can.”
So, what does this mean to you? In IRS speak, the 199A clarification “provides for a safe harbor under which a rental real estate enterprise will be treated as a trade or business.” And what do you have to do to drop anchor in that safe harbor? According to the IRS, “The rental real estate enterprise must satisfy the requirements of the proposed revenue procedure,” so let’s take a look at what that means.
The IRS defines rental real estate as “an interest in real property held for the production of rents and may consist of an interest in multiple properties.” So, you can have a partner(s) and you can own one building or a stable of properties, with this IRS proviso:
The individuals or flow-through entities “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 as a single enterprise.” One additional qualifier: “Commercial and residential real estate may not be part of the same enterprise."
So, now that the IRS considers your rental real estate enterprise a “trade or business,” what does that mean in terms of how you run your business? You most likely meet the IRS definition of a trade or a business, which is “an activity carried on for the livelihood or in good faith to make a profit.” And here is an interesting tidbit from the IRS website: “You do not need to actually make a profit to be in a trade or business as long as you have a profit motive.”
The safe harbor requirements that must be satisfied to keep your “trade or business” qualification and to be eligible for the 20% tax deduction include:
- Maintaining separate books and records that record both expenses and income for each of your rental real estate enterprises.
- Performing at least 250 hours of rental services each taxable year.
- Keeping detailed and contemporaneous records on the services performed.
Regarding the “services” mentioned in procedure #2, they can be performed by you, people who work for you and independent contractors. If you do the math, 250 hours of services comes out to one hour a day, Monday-through-Friday for 50 weeks of the year. But, as stated, careful records of those services must be kept. Qualifying services include maintenance, collecting rent, efforts made to rent the property, providing services to tenants, paying of expenses, and repairs,
It is also important to be aware of activities not considered hours of service, since including them in your tally could jeopardize your “trade or business” status and in turn your 199A 20% tax deduction. Non-qualifying activities include reviewing financial statements, arranging financing, reviewing operation reports and procuring property, Also, just about any activity having to do with long-term capital improvements does not qualify, including their planning, management, and their actual construction.
As to records referenced in procedure #3, they would include logs or time sheets that recorded all the hours and dates when specific services were performed, a description of those services, and who performed them. The good news is none of this applies to years prior to January 1, 2019.
Once you determine that you qualify as a trade or business under the safe harbor rules, you will be required to attach a statement to the tax return that is claiming the deduction or passing through the deduction. The statement needs to certify that the requirements of this revenue procedure have been met. The statement must be made under the penalty of perjury and it must be signed by the taxpayer or the authorized representative.
All of that said, according to the IRS, “If an enterprise fails to satisfy the requirements of this safe harbor, the rental real estate enterprise may still be treated as a trade or business for purposes of section 199A if the enterprise otherwise meets the definition of trade or business in § 1.199A-1(b)(14).”
Many taxpayers own real estate under a triple net lease arrangement. A triple net lease 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. This notice specifically excludes triple net lease arrangements from safe harbor eligibility. Also excluded is real estate used by a taxpayer as a residence for any part of the year.
One additional item to note is that by treating the rental activities as a trade or business, real estate entities will be required to issue 1099s to unincorporated vendors.
The terms of the new 199A “clarification,” that have been presented here are just highlights of something very complex, but something of which you should be aware. If you are involved in the rental real estate business, please contact your Prager Metis tax expert to discuss whether you qualify for the 199A deduction and what planning opportunities are available.