CPA, Partner, Practice Leader, Federal Tax Services
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Treasury finalizes real estate safe harbor for qualified business income deduction
The IRS and the U.S. Treasury Department issued a safe harbor in Revenue Procedure 2019-38 on Sept. 24, 2019, to help resolve uncertainty about when an interest in rental real estate rises to the level of a trade or a business under Section199A of the Internal Revenue Code (IRC). Taxpayers may still qualify for the deduction without the safe harbor if they otherwise meet the definition of a trade or business. Revenue Procedure 2019-38 applies to taxable years ending after Dec. 31, 2017, and incorporates IRS and Treasury considerations following public comment on Notice 2019-07, an earlier pronouncement that provided for a similar safe harbor. Taxpayers may rely on the safe harbor in Notice 2019-07 for the 2018 taxable year.
Section 199A can provide noncorporate taxpayers a deduction of up to 20% of qualified business income (QBI) from each of their qualified trades or businesses. A qualified trade or business generally is any trade or business other than a specified service trade or business (SSTB) or work performed as an employee; however, under certain income thresholds, generally no trade or business is treated as an SSTB. Qualified trades or businesses include those operated through partnerships, S corporations (S-corps), sole proprietorships, and dividends from qualified real estate investment trusts (REITs) or publicly traded partnerships.
Rental real estate enterprise
To determine if the safe harbor is satisfied, the revenue procedure applies a test (described below) on a “rental real estate enterprise” basis. For this safe harbor, a rental real estate enterprise is an interest in real property held for the production of rents. This interest may be in a single property or multiple properties but must be held by the taxpayer or relevant passthrough entity (RPE) directly or through a disregarded entity.
Similar property
Taxpayers or RPEs with multiple property interests may, but are not required to, treat similar properties as a single enterprise for Section 199A purposes. Properties are similar if they are part of the same category. For example, commercial property may only be included in the same enterprise with other commercial property, and residential property may only be included in the same enterprise with other residential property.
If a taxpayer or RPE treats similar properties as a single enterprise under this safe harbor, it must continue to do so for all similar property, including newly acquired property, provided the taxpayer relies on this safe harbor. However, if a taxpayer or RPE treats its property interests as separate rental real estate enterprises, it may opt to treat its interests in similar properties as a single enterprise in a future year.
Mixed-use property
Mixed-use property is a single building that combines residential and commercial units. It may be treated as a single rental real estate enterprise (which cannot be combined as similar property), or it may be bifurcated into separate residential and commercial interests, and each bifurcated interest may then be treated as similar property in accordance with the guidance provided in the previous paragraph.
The rental real estate enterprise test: Safe harbor requirements
A rental real estate enterprise may be treated as a trade or business for purposes of Section 199A by satisfying all of the following four requirements:
- Maintain separate books and records that reflect income and expenses for each rental real estate enterprise. If a rental real estate enterprise includes more than one property, this requirement may be satisfied if income and expense information statements for each property are maintained and then consolidated.
- Satisfy the 250-hour requirement
o Taxpayers in existence for less than four years: Taxpayers need at least 250 hours of “rental services” (explained below) performed per year related to the enterprise.
o Taxpayers in existence for more than four years: Taxpayers need at least 250 hours of rental services performed per year related to the enterprise in any three of the five consecutive tax years ending with the current taxable year.
- Maintain contemporaneous records of hours of service, descriptions of the service, dates of service, and identification of those who performed the service.
- Attach a statement to an originally filed return for each tax year relying on this safe harbor. The statement must include 1) a description of all properties in each rental real estate enterprise, 2) a description of all properties acquired or disposed of during the taxable year, and 3) a representation that the requirements of this revenue procedure are met.
Note: Descriptions of all properties should include the address and rental category (residential or commercial).
Rental services for the 250-hour requirement
Rental services include:
- advertisements to rent or lease real estate,
- negotiation and execution of leases,
- verification of information in prospective tenant applications,
- rent collection,
- daily maintenance, operation, and repair,
- management of real estate, and
- supervision of employees and independent contractors.
These services may be performed by owners, agents of the owners, or employees. Services do not include financial or investment management activities.
Types of property not eligible for this safe harbor
Properties that may not be included in a rental real estate enterprise and are therefore ineligible for this safe harbor are 1) real estate used by the taxpayer as a residence, 2) real estate rented or leased under a triple net lease, 3) real estate rented to a trade or business conducted by a taxpayer or RPE commonly controlled under IRC Section 1.199A-4(b)(1)(i), or 4) the entire rental real estate interest if any portion of the interest is treated as an SSTB.
The IRS has clarified when a rental real estate enterprise qualifies as a trade or business for purposes of Section 199A. Although Revenue Procedure 2019-38 generally replaces the previous safe harbor provided in Notice 2019-07, the notice can still be relied upon for tax years beginning in 2018. It is paramount that taxpayers understand that contemporaneous records are required in order to qualify. Taxpayers should consult their tax advisors to ensure their eligibility for and satisfaction of the safe harbor requirements. Where a safe harbor does not apply, a rental real estate enterprise might still rise to a level of a business, depending on the facts and circumstances.
Brian Newman, Partner, National Tax
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