IRC 199A – Favorable Treatment for Real Estate?

Take-Away: As a wild generalization,  from a recent IRS Notice it appears that the owners of commercial real estate are given favorable treatment in their ability to claim an IRC 199A qualified business income tax deduction. As is often the case, however, the ‘devil is in the details.’

Caveat: I am the first to confess that I find IRC 199A bewildering. Consequently, my interpretation of its provisions and the Final Regulations should be taken with a grain of salt.

Background: If a taxpayer owns certain types of trades or businesses, he/she may be eligible to claim a 20% income tax deduction taken against their qualified trade or business income. [I will ignore the several exceptions, limitations, etc. to that generalization of the income tax deduction, which is usually where I start to get lost.] A taxpayer who is in the 37% marginal federal income tax bracket could, with the full IRC 199A income tax deduction, actually pay income taxes at an effective marginal federal rate of 29.6% which makes qualifying for the IRC 199A deduction important. In order to qualify, the business must be a ‘pass-through’ entity, e.g. LLC, partnership, S corporation, or sole proprietorship. Moreover, the business must be an active trade or business as described in IRC 162.

Active Trade or Business: Normally a business entity that owns and leases real estate is viewed as a passive business entity, not an active trade or business. Consequently, under IRC 162, many real estate owning businesses normally will not meet the definition of an active trade or business.

Final Regulations: Yet the Final IRC 199A Regulations seem to come to the rescue of a business owner who leases real estate and licenses tangible or intangible real estate. Those Final Regulations state, in part 1.199A-4(b) (1) (i): “..rental or licensing of tangible or intangible property (rental activity) that does not rise to the level of a Section 162 trade or business is nevertheless treated as a trade or business for purposes of Section 199A, if the property is rented or licensed to a trade or business conducted by the individual or a relevant pass through entity] which is commonly contributed under 1.199A-4(b)(1)9(i) (regardless of whether the rental activity and the trade or business is are otherwise eligible to be aggregated under 1.199A-4(b)(1).) [See Reg.1.199A-1(b) (14.)] In other words, if a business owner ‘wraps’ his/her commercial real estate in an LLC, for example,  and then the LLC leases the real estate to the business owner’s operating business, that LLC will still be considered to be an active trade or business, even though the LLC would historically not fit that IRC 162 classification.

Aggregation: A real estate rental enterprise that has common control, i.e. 50% or more common ownership [determined using the ownership attribution rules of IRC 267(b) or IRC 707(b)] with an active trade or business will be treated as a qualifying trade or business for purposes of the IRC 199A income tax deduction. Therefore, if a business owner holds the real estate in an LLC, or the business owner is a 50%+ partner in a partnership that leases the real estate to the owner’s operating business conducted as an S corporation, the two entities will be aggregated for purposes of the income tax deduction.

Safe Harbor: The IRS also issued along with the Final Regulations a safe harbor for real estate owners, under which presumption, the real estate enterprise will be treated as an active trade for business, solely for the purposes of qualifying for the IRC 199A income tax deduction. To fall within this safe harbor, IRS Notice 2019-7 requires the business owner to: (i) maintain adequate records of the rental real estate activities undertaken; and (ii) provide at least 250 hours of time to that rental activity each year. The 250 minimum hour time commitment requirement for the safe harbor does not include: (i) buying and selling rental properties; (ii) any travel to and from the real properties for inspections; and (iii) the owner reviewing financial statements with regard to the real properties.

Residential Rentals: Residential and commercial property cannot, however, be aggregated and managed for purposes of determining whether there is an active trade or business. These parcels will not be treated as part of the same business enterprise. Each property must be tested separately for the 250 hour per year safe harbor However, it is unclear in a situation where both residential and commercial are combined in a single real property. Example: The landlord rents a storefront with an apartment above the store, both in the same building. The storefront rental is clearly commercial. The apartment rented upstairs is obviously residential. The Final Regulations do not provide any example when this dual-use rental activity is conducted from the same parcel of real estate.

Triple Net Leases: A landlord with an active non-triple-net lease arrangement with tenants can be sure of being considered to be conducting an active trade or business. With regard to triple-net-leases of commercial real estate, it may still be possible to claim the IRC 199A income tax deduction, but the landlord will have to be in a position to prove that, at a minimum, the safe harbor requirements are met.

Suggestions: If a real estate owner leases real estate, he/she should keep separate records with respect to each parcel that is the subject of the lease. If possible, when negotiating a renewal of an existing lease, the landlord show attempt to retain some responsibilities under the lease (charging a higher rent to cover those responsibilities) in order to avoid engaging in a pure triple-net-lease which is presumptively not an active trade or business. In addition, the landlord should maintain contemporaneous time records, documenting the time devoted to specific task associated with operating the rental business, and classifying those specific services. Example: The time a landlord devotes to repairs made to the real estate will satisfy the annual 250-hour minimum. In contrast, the time devoted by a landlord to remodeling the real estate will not count towards the annual 250-hour safe harbor. Of course, no definition or example is provided by the IRS to distinguish between a repair versus a remodel. Some commentators have actually suggested that the landlord be videotaped when visiting the rental property in order to document that the property was actually inspected, or when repairs are actually made to the rental real estate.

Conclusion: Taken as a whole, the IRC 199A Final Regulations, coupled with Notice 2019-7, tend to favor real estate enterprises and ventures in contrast to other businesses or the category of specified service trades or businesses. There appears to be a willingness to treat a passive rental activity as an active trade or business to permit the owner to claim an IRC 199A income tax deduction, but close attention needs to be given to the examples provided in the Final Regulations and the companion Notice.