IRS Safe Harbor on Section 199A Impacts 2018 Filing for Rental Real Estate
The Tax Cuts and Jobs Act added a new deduction equal to 20 percent of qualified income (QBI) from a business operated directly by a taxpayer or through a pass-through entity. The deduction is only available with respect to income from a trade or business. It is unclear under IRS regulations when a rental activity rises to the level of a trade or business, allowing the rental income to be eligible for the 20 percent deduction or the rental loss to reduce the deduction.
The IRS issued Notice 2019-07 on January 18, 2019, providing a limited safe harbor to establish that a rental activity rises to the level of a trade of business.
The good news is that we have a safe harbor. The bad news is that we can only use it in limited situations. The other good news is that we can still use a facts and circumstances analysis to support the QBI deduction outside of the safe harbor.
This article comments on the urgent issues raised by this guidance and offers some insight for how to apply it to your 2018 tax filings. Our approach can help taxpayers who don’t qualify for safe harbor treatment to establish their tax return reporting positions.
Safe harbor requirements
To qualify as a trade or business and be eligible for the 20 percent qualified business income deduction (QBID) under the safe harbor the rental real estate enterprise must meet the following requirements:
1. Separate books and records must be maintained for each rental real estate enterprise.
2. For tax years ending prior to December 31, 2023, 250 or more hours of “rental services” must be performed by or for the real estate enterprise each year. The 250 hours of rental services can be performed by owners, employees, agents, or independent contractors.
Rental services include:
- Advertising for rent or lease
- Negotiating and executing leases
- Verifying tenant applications
- Collection of rent
- Daily operation, maintenance, and repair of property
- Management of the real estate
- Purchase of materials
- Supervision of employees and independent contractors.
Rental services do not include:
- Financial or investment management services
- Arranging financing
- Procuring property
- Studying or reviewing financial statements or operating reports
- Planning, managing, or constructing long-term capital improvements
- Time spent traveling to and from real estate
3. Taxpayers and tax filing entities will have to implement time tracking systems beginning with 2019 if they are going to rely on this approach, and the 250 test will be applied annually. The taxpayer will have to maintain logs to document:
- Hours of services
- Description of services
- Dates such services were performed
- Who performed the service
Rental real estate arrangements excluded from 199A treatment under the safe harbor
Two real estate categories do not qualify for 199A treatment under the safe harbor:
- Real estate used as residence for any part of the year under IRC Sec 280A, including vacation homes and second residences
- Triple net lease real estate, where the tenant is required to pay all of the taxes, fees, insurance, utilities, and maintenance associated with the building or the portion of the building subject to such an arrangement.
Safe harbor examples
Multi-family rentals, self-storage, and hospitality rental arrangements will often meet the requirements of the safe harbor.
The various responsibilities of the property owner and the labor hours necessary to deliver on such responsibilities, and the fact that leases are not triple net leases makes it likely that multi-family apartment rentals will fit within the safe harbor requirements.
Self-Storage and hospitality (hotels)
These asset classes have similar operating requirements and attributes as multi-family apartments, so where the owner and the operator are the same, it is likely that they would also meet the safe harbor requirements.
What do you do if you don’t meet the safe harbor requirements?
Many real estate enterprises will not be able to meet the requirements because of their inability to meet all the requirements. For example, we anticipate that many rental arrangements that fall under the following categories will not be eligible for the safe harbor::
- Single family homes
- Single tenant industrial
- Any property subject to a triple net lease, including mixed use properties
- Single tenant retail
If you are not able to rely on the safe harbor, you will want to assess your situation under the broader tests under IRC Sec. 162 using the following approach:
- Consider whether the “self-rental” rental rule applies, which allows a rental enterprise to be considered a trade or business if the tenant is commonly owned and generates QBI.
- Review the facts and build your case for the rental enterprise meeting the broader test under IRC Sec. 162. When taking this approach, it is important to consider the different factors that have been raised by the IRS and the courts in assessing whether taxpayers’ activities have risen to the level of being considered a trade or business. The following factors influence whether a rental real estate activity is a trade or business for tax purposes:
- The type of rented property (commercial real property versus residential property)
- The number of properties rented
- The owner’s or the owner’s agents day-to-day involvement
- The types and significance of any ancillary services provided under the lease
- The terms of the lease (for example, a net lease versus a traditional lease and a short-term lease versus a long-term lease
How we can help
At CLA, we work with our clients to review and compare their rental enterprise activities to the IRC Sec. 162 factors established by IRS and the courts. We help them document in writing the elements that will support their decisions when it comes to filing their tax returns and we have found that an in-depth exploration of an enterprise’s rental activities frequently reveals evidence that supports a QBI deduction. And where the deduction may not be applicable, we often uncover structuring alternatives that will help bring benefits in the future.
Our experience interviewing property managers, reviewing property management agreements, and examining lease agreements has helped our clients make the decisions necessary to file their tax returns for 2018.