IRS Finalizes Section 199A Real Estate Safe Harbor
In September, the IRS issued Revenue Procedure 2019-38 which finalizes the section 199A real estate safe harbor. Although much of the proposed safe harbor is contained in the final version, there are some important differences. This article analyses the final safe harbor rules.
Background: Section199A, as created under the Tax Cuts and Jobs Act of 2017, provides a 20% deduction of qualified business income for non-C corporate taxpayers. A taxpayer’s qualified business includes those operated through a partnership, S corporation, or sole proprietorship. A 20% deduction can also be secured on the aggregate of real estate investment trust dividends and qualified publicly traded income.
A fundamental requirement for the deduction is that the activity must rise to the level of a trade or business. Section 199A(d) defines a qualified trade or business as any trade or business other than a specified service trade or business. This means a real estate rental activity can count if it rises to the level of a trade or business. The problem is that there is a lot of grey in this area. There are court cases where one rental is enough to have a trade or business and other cases where one rental is not enough.
The new IRS procedure removes this uncertainty by providing a safe harbor. If the client satisfies the rules,they are allowed the 20% deduction even if the rental activity on its own does not rise to the level of a trade or business. If a client fails to meet the safe harbor rules they can still take the 20% deduction on real estate rentals if either the activity rises to the level of a trade or business or the property is rented to a trade or business where there is common ownership.
Real Estate Enterprises: For purposes of the safe harbor, this is the term used to describe rentals that may be eligible for the deduction. An enterprise may consist of one or more properties. Only rentals in the same category may be grouped. Commercial and residential rentals cannot be combined. Mixed-use property may be treated as a single rental activity or bifurcated into residential and commercial. Once property is grouped for this safe harbor it must stay that way in later years, including newly acquired property. A taxpayer who has not grouped may choose to do so in a later year.
Final safe harbor rules: The determination is made each year. Each real estate enterprise will be treated as a separate trade or business if it meets the following four requirements:
- Separate books must be maintained for each real estate enterprise.
- For rental real estate enterprises that have existed for less than four years, 250 service or more hours of service (as defined below) are performed each year. For enterprises that have existed for at least four years, the requirement is met if 250 or more hours of service are performed in any three of the previous five years.
- The taxpayer maintains contemporaneous records regarding: hours of service, description of the services performed, dates when the work was done and who performed the work. If the work is done by employees or independent contractors, the taxpayer can provide a description of the services performed and the amount of time the employee or contractor generally spends on that work. Note: The contemporaneous record keeping requirement applies to tax years beginning after January 1, 2020. This is a reprieve from the proposed rules.
- The taxpayer or relevant pass through entity (RPE) attaches a statement to a timely filed original return (or an amended return for 2018 only) for each year the safe harbor is relied upon. If more than one real estate enterprise relies on this safe harbor it is only necessary to submit one statement but the statement must list the required information separately for each real estate rental enterprise. The statement must include: (A) A description (including the address and rental category) of all real estate properties; (B) A description (including the address and rental category) of rental real estate acquired and disposed of during the year; and (C) A representation that the requirements of the revenue procedure have been met.
Rental Services: Rental services that count towards the 250 hour requirement include: advertising; negotiating and executing leases; verifying applicant information; collecting rent; daily operation, maintenance, and repair (including purchasing of materials and supplies); management of the real estate; and supervision of employees and independent contractors. Rental service does not include time spent traveling to/from the rental, nor financial or investment management such as arranging financing, procuring property, and studying and reviewing financial information.
Real Estate not available for the safe harbor:
- Property used under 280A(d)
- Triple net lease
- Real estate rented to a trade or business conducted by the taxpayer or RPE which is commonly controlled
- The entire rental if any portion is treated as a SSTB because it is rented to a common service business owner