24-Jan-19
Final IRC 199A Regulations Part III – Rental Real Properties
Take-Away: The Final IRC 199A Regulations, and IRS Notice 2019-7 seem to create a safe harbor that permits owners of rental real estate to qualify for the IRC 199A income tax deduction. As a generalization, ‘triple-net’ leased real estate will be excluded from the IRC 199A income tax deduction. The rental real estate owner will have to devote at least 250 hours a year to his/her “Rental Real Estate Enterprise” for it to be treated as an ‘active trade or business’ that qualifies for the IRC 199A income tax deduction.
Background: IRS Notice 2019-7 provides tentative guidance, in the form of a proposed Revenue Procedure, that will describe when real estate rental activity will rise to a level that will be considered an ‘active trade or business’ that is entitled to claim an IRC 199A income tax deduction. An individual who owns rental real estate, who is at the 37% marginal federal income tax bracket, would after the IRC 199A tax deduction is claimed have an effective marginal income tax rate of 29.6%. The Service is currently asking for comments on under what circumstances should rental real estate activity be treated as an active trade or business. While the Revenue Procedure is not yet final (it will apply for 2019, but not 2018) it acts as a safe harbor for some individuals who own rental real estate.
Safe Harbor Conditions: The Notice provides a safe harbor for some rental real estate owners subject to certain conditions. In order to rely on the safe harbor, the individual must own the real estate directly or through another legal entity that is disregard for income tax purposes, like a partnership or a single-member LLC. The individual can elect to either treat a single real property as a separate enterprise, or all similar real estate properties can be elected to be aggregated and treated as a single real estate enterprise for the purpose of qualifying for the safe harbor. Several requirements must be met by the real property owner in order to qualify for the IRC 199A safe harbor:
- Separate Accounting of Income and Expenses: Separate books and records must be maintained to reflect income and expenses for each real property ‘enterprise’;
- Contemporaneous Records of Hours of Service Performed: Contemporaneous records must be kept, that include keeping time reports, logs, or similar records with regard to the hours of service that are performed, a description of all services performed, and the dates of those services- this contemporaneous ‘record-keeping rule’ applies starting in 2019;
- 250 Hours Per Year: For years 2018 through 2022, 250 or more hours of rental services must be performed by the real property owner in order for the owner to qualify for the IRC 199A safe harbor. Rental services does not include arranging for financing, investing, buying property, or reviewing financial statements, nor will it count any time that is spent by the owner traveling to and from the real estate. Hours of service that will count against the 250-hour annual minimum include: advertising; negotiating and executing leases; verifying prospective tenant applications; collecting rent; daily operation, maintenance and repairs; management of the real estate; the purchase of materials; and supervision of employees and independent contractors.
Exclusions: Triple-Net Leases and Personal Residences: The Notice clearly states that real estate that is rented or leased under a triple-net-lease is not eligible under the IRC 199A safe harbor, even though the owner participates in an active business of entering into and selling triple-net leases and thus may still qualify as an ‘active trade or business’ under IRC 162 at common law. If the landlord is responsible for some portion of the maintenance, taxes, fees, or insurance expenses then the leased real estate will not be treated as a triple-net-lease. The safe harbor also will not be available to an individual who rents his/her personal residence out for any part of the calendar year. Consequently, any legal entity that holds a personal residence will probably disqualify the entire legal entity from the safe harbor tax deduction opportunity.
Conclusion: As a result of this opportunity to claim an income tax deduction, some landlords may want to consider renegotiating existing leases to no longer use a triple-net-lease if their goal is to qualify for the IRC 199A income tax deduction.
Creating a fairly clear safe harbor for rental real property owners is a positive move by the IRS. It remains to be seen, however, how many real property owners will be able (or willing) to satisfy the 250 hour per year condition, especially those real property owners who only own one or two rental properties. All in all, the Notice of the anticipated Revenue Procedure is a step in the right direction.