The Tax Cuts and Jobs Act added a new section 199A deduction equal to 20 percent of qualified income 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. But it is unclear 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 Rev. Proc. 2019-38 on September 24, 2019, finalizing a limited safe harbor initially proposed in in January (IRS Notice 2019-07) for taxpayers who are direct and indirect owners in rental real estate enterprises. If you qualify for the safe harbor, you can be assured your rental activities will qualify as a business and that the rental income will be eligible for the 20% deduction (subject to possible limitations). Even if you do not qualify for the safe harbor, you may be able to use a facts and circumstances analysis to support the 20% deduction.
Now that the safe harbor guidance has been finalized, there are urgent issues that some real estate enterprises will need to navigate. The following outlines how you apply the safe harbor to your 2019 tax filings, and what your options are if you don’t qualify.
Rev. Proc. 2019-38 safe harbor
To 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:
- Maintain separate books and records for each rental real estate enterprise
- Perform 250 or more hours of “rental services” each year (for enterprises that have been in existence for more than four years, the 250-hour requirement must be satisfied in three of the five years ending with the tax year). The 250 hours of rental services can be performed by owners, employees, agents, or independent contractors. A rental real estate enterprise can include multiple properties of the same general category (commercial or residential). A commercial rental cannot be part of the same enterprise as a residential rental and vice versa.
Rental services include:
- Advertising for rent or lease
- Negotiating and executing leases
- Verifying tenant applications
- Rent collection
- Daily operation, maintenance, and repair of property
- Managing the real estate
- Purchasing 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
- Beginning in 2020, real estate enterprises must maintain contemporaneous documentation similar to the way a law firm might track time spent on client matters. You should document the following items to satisfy the 250-hour requirement:
- Hours of services
- Description of services
- Dates such services were performed
- Who performed the service
The final safe harbor rules simplify requirements to substantiate time spent by employees and independent contractors. Taxpayers are allowed to take into account the amount of time the employee or contractor generally spends on rental services, rather than requiring detailed time logs, as long as the taxpayer retains the time, wage, or payment records for the employee or contractor.
Rental real estate arrangements excluded from 199A treatment
Four categories of rental properties are not eligible for the safe harbor, regardless of whether the three requirements discussed above are satisfied:
- Property used as residence for any part of the year, such as a vacation home
- Property subject to a triple net lease (i.e., a rental where the tenant is required to pay the taxes, insurance, utilities, and maintenance associated with the property)
- Property rented to a business with common ownership (i.e., a self-rental)
- Property where a part is treated as a specified service business under a nuanced rule
Real-life application of the safe harbor
The following example illustrates the application of the safe harbor:
Example: Abby owns two commercial buildings that she rents to third parties on a full-service basis (i.e., the leases are not triple net leases). Abby prepares financial statements for each property. Each year, Abby and third-party vendors spend 150 hours of rental services per property (300 hours total). Abby keeps contemporaneous time records to prove the amount of time spent on the rentals and treats the two commercial rentals as a single rental enterprise. The rental enterprise is eligible for the safe harbor and will be treated as a business for purposes of Sec. 199A if Abby makes the safe harbor election.
Variation: If one of the buildings were leased to an S corporation manufacturing business wholly owned by Abby, the rental is a self-rental and is thus ineligible to be part of the rental real estate enterprise. The self-rental is automatically deemed to be a business for purposes of Sec. 199A under a special self-rental rule. The remaining rental would only involve 150 hours of rental services and thus would not satisfy the 250-hour requirement for the safe harbor. The rental might otherwise qualify as a business, however, depending on the facts.
What if you don’t meet the safe harbor requirements?
Many real estate enterprises will not qualify for the safe harbor election because of their inability to meet all of the requirements. For example, your rental might be ineligible for the safe harbor because it involves a triple net lease, or the 250-hour requirement is not satisfied. If you don’t qualify for the safe harbor, the following approach may help you benefit from the 20% deduction:
- 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.
- Consider whether the rental rises to the level of a business based on the relevant facts, such as:
- 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)
- In some cases, it may be preferable to avoid business status (e.g., where the rentals generate a loss that would reduce the 20% QBID). You may want to evaluate whether business classification of your rentals is actually better.
- Consider whether any changes can be made to your lease arrangements and rental operations to obtain more favorable tax treatment.
How we can help
At CLA, we can help you determine whether you are eligible for the safe harbor and, if not, consider planning measures to qualify for the safe harbor. Even if the safe harbor is not available, we can evaluate whether there is a way for your rental activities to qualify as a business without the safe harbor based on factors established by IRS and the courts. We can also explore whether any changes to your leases could improve your tax situation.
Our experience interviewing property managers, reviewing property management agreements, and examining lease agreements can help you make the decisions necessary to file your tax returns.