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George F. Bearup, J.D. Senior Legal Trust Advisor

9-Sep-19

IRC 199A – Safe Harbor for Owners of Rental Properties

Take-Away: Late last week the IRS published Revenue Procedure 2019-38  in anattempt to provide some clarity when the owner of rental real estate can claim the IRC 199A 20% qualified income tax deduction. While some clarity is provided, there is still doubt about whether the owner of real estate leased on a ‘triple net’ lease can claim the 20% income tax deduction.

Background: IRC 199A provides, through a series of complex income calculations, income limitations, and professional exclusions, an income tax deduction to the owners of ‘pass-through’ entities [S corporations, LLCs, partnerships and sole proprietorships.] The entity must be engaged in a ‘trade or business’ in order to become eligible to claim the 20% income tax deduction. Through Regulations and this new Revenue Procedure, the IRS has created a safe harbor when the business will be able to claim the income tax deduction. [Reg. 1.199A-1 through 1.199A-6.] A business will even be eligible to claim the income tax dedication if it leases or licenses tangible and intangible property (rental activity) if the property is rented or licensed to some trades or businesses which are commonly controlled, even when that activity, standing alone, does not rise to the level of a ‘trade or business’ as defined in IRC 162.

Safe Harbor Rule: A safe harbor is available to a taxpayer who seeks to claim the income tax deduction under IRC 199A. If the safe harbor is met, rental real estate will be treated as a single trade or business for purposes of applying the IRC 199A Regulations, including the Regulation’s aggregation rules with other business activities. However, the taxpayer must satisfy all the requirements set forth in the new Revenue Procedure. Those requirements follow:

  • Annual Determination: The determination to use the safe harbor must be made annually. Each rental ‘real estate enterprise’ will be treated as a single trade or business, but only if the following requirements are satisfied.
  • Separate Books and Records: Books and records must be maintained to reflect the income and expenses for each ‘rental real estate enterprise.’ If properties are consolidated into a single enterprise, there must be separate income and expense information statements available for each property.
  • 250 Hour Rule: For ‘rental real estate enterprises’ established less than 4 years, 250 or more hours of rental services must be performed each year with respect to that ‘rental real estate enterprise.’ If the business is more than 4 years old, this 250 hour per year requirement only has to be satisfied in any 3 of the 5 consecutive years that end with the year in question.
  • Contemporaneous Records: The taxpayer must maintain contemporaneous records, including time reports, logs, etc. regarding: (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. Employees and independent contractors can perform the services; if that is the case, then the taxpayer can provide a description of the rental services provided by the employee or independent contractor. These records must be available for inspection at the IRS’ request.
  • Rental Services: Some obvious activities fall within the 250-hour per year rental services. Other services will not be available to satisfy the 250-hour per year requirement. Included within countable rental services are: (i) advertising to rent or lease; (ii) negotiating and executing leases; (ii) verifying information furnished by prospective tenants; (iv) collecting rent; (v) daily operation, maintenance and repair of the property, including the purchase of materials and supplies; (vi) management of the real estate; and (vii) supervision of employees and independent contractors. Excluded from countable services are: (a) financial or investment management activities; (b) arranging financing; (c) procuring the property; (d) studying and reviewing financial statements or reports on properties;  (e) improving, e.g. remodeling, property; and (f) traveling to and from the real estate. No effort was made to distinguish a repair (countable) from a remodel or improvement (not countable) of the real property.
  • Safe Harbor Annual Statement: The taxpayer must attach a statement on a timely filed tax return for each year that the taxpayer relies on the safe harbor. This statement will require a description and address of the real properties, the classification of the real property (commercial or residential) and a representation that the requirements of this Revenue Procedure have been satisfied.

Rental Real Estate: A ‘rental real estate enterprise’ can consist of a single property, or interests in multiple properties. The taxpayer must hold each interest directly or through a pass-through entity which is disregarded as an entity separately from its owner. The properties must, however, be similar, meaning that the property must fall within two separate categories, either residential or commercial. What this means is that commercial real property can be combined and treated as a single ‘trade or business’ and the same with residential real property, but residential and commercial leased real estate cannot be combined and treated as a single ‘trade or business.’

Future Acquisitions: Once the taxpayer treats interests in similar commercial, or residential, real property as a ‘single real estate enterprise’ under the safe harbor, the taxpayer must continue to treat the interests in all similar properties, including newly acquired real property, as a ‘single rental real estate enterprise’.

Mixed-Use  Properties: A concern raised when the Regulations were first published was with regard to a mixed-use real property, where the lower floor was retail commercial space and upper floors in the same building were residential. The Revenue Procedure notes that mixed-use property may be treated as a ’single rental real estate enterprise.’ However, an interest in a mixed-use real property, if treated as a ‘single rental real estate enterprise’ cannot be treated as part of the same enterprise as other residential, commercial, or mixed-use property.

Excluded from the Safe Harbor: Some real estate entities will be denied the use of the safe harbor. The entities excluded from claiming the safe harbor are: (i) real estate that is used by the taxpayer, including an owner or beneficiary of a ‘real property enterprise’ as a residence [defined in IRC 280A(d);]  (ii) real estate rented to a trade or business conducted by a taxpayer or a ‘rental real estate enterprise’ which is commonly controlled under Regulation 1.199A-4(b)(1)(i); and (iii) the entire real estate interest if any portion of the interest is treated as a specified service trade or business , i.e. excluded professionals and high earning individuals like performers or professional athletes.

Triple Net Real Estate Excluded:  Real estate that is rented or leased under a triple net lease, where the tenant agrees to pay the taxes, fees, insurance, and maintenance activities in addition to the payment of rent and utilities. The IRS observes, however,  that even if a business does not qualify to claim the safe harbor “the failure to satisfy the requirements of this safe harbor does not preclude a taxpayer or the Service from otherwise establishing that an interest in rental real estate is a trade or business for purposes of section 199A.”

Conclusion: This Revenue Procedure is not overly helpful, and seems to be primarily a re-hash of what the Final Regulations covered with regard to claiming an IRC 199A income tax deduction. Triple net leases will not qualify for the safe harbor, but apparently they might still qualify for the IRC 199A income tax deduction, but no examples have been provided to show how this ability to claim the IRC 199A tax deduction using a triple-net lease arrangement might be achieved. Still, it is helpful to know that some rental businesses, albeit passive in nature, might still qualify to claim the deduction. And it is always helpful to keep in perspective when structuring a business that the IRC 199A 20% income tax deduction has a ‘shelf-life of only 6 more years.