IRS provides safe harbor for 20% pass-through deduction for rental real estate

I. Introduction

On January 18, 2019, the IRS published much anticipated guidance addressing the question of whether rental real estate businesses can be treated as generating qualified business income (“QBI”) for purposes of the 20% passthrough deduction of § 199A of the Internal Revenue Code of 1986, as amended (“Code”).  This guidance was issued in Notice 2019-07 (“Notice”) in the form of a proposed revenue procedure.  The Notice was issued as part of a wave of guidance released by the IRS on the same day addressing the application of Code § 199A, including final regulations.

II. Code § 199A

Code § 199A was enacted by the Tax Cuts and Jobs Act of 2017. It provides for a deduction of up to 20% of a non-corporate taxpayer’s QBI from a qualified trade or business, subject to certain limitations. A qualified trade or business is defined in Code § 199A(d) as “any trade or business other than (A) a specified service trade or business, or (B) the trade or business of performing services as an employee.”

III. Proposed Revenue Procedure Under Notice 2019-07

There has been uncertainty about whether a rental real estate business fits within the definition of a qualified trade or business under Code § 199A. For this reason, a proposed revenue procedure contained in the Notice provides for a safe harbor for so-called rental real estate enterprises, allowing them to be treated as a trade or business for purposes of § 199A if certain conditions are satisfied, or so long as they meet the definition of a trade or business provided in Treas. Reg. § 1.199A-1(b)(14), which was part of the final regulations published contemporaneously with the Notice. Certain passthrough entities (e.g., partnerships and S corporations) may also rely on the safe harbor to determine whether a rental real estate enterprise is a trade or business for purposes of Code § 199A.

Under the proposed revenue procedure, a rental real estate enterprise is defined as “an interest in real property held for the production of rents and may consist of an interest in multiple properties.” The interest must be held directly or through a disregarded entity. Each property must be treated as a separate enterprise or all similar properties (e.g., all commercial properties or all residential properties) must be treated as a single enterprise, subject to an exception discussed below. Whichever treatment is used cannot be changed from year-to-year unless a significant change in facts and circumstances has occurred.

A rental real estate enterprise meeting the definition above will be treated as a trade or business solely for purposes of Code § 199A if the following requirements are satisfied:

“(A) Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise;

(B) For taxable years beginning prior to January 1, 2023, 250 or more hours of rental services are performed . . . per year with respect to the rental enterprise. For taxable years beginning after December 31, 2022, in any three of the five consecutive taxable years that end with the taxable year (or in each year for an enterprise held for less than five years), 250 or more hours of rental services are performed . . . per year with respect to the rental real estate enterprise; and

(C) The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, regarding the following: (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.”

The proposed revenue procedure includes examples of what will (and will not) be considered “rental services” referenced in Part (B) above and provides that Part (C) will not apply to taxable years beginning prior to January 1, 2019.

Additionally, a statement must be signed and attached to the return on which the deduction is being claimed, which states: “Under penalties of perjury, I (we) declare that I (we) have examined the statement, and, to the best of my (our) knowledge and belief, the statement contains all the relevant facts relating to the revenue procedure, and such facts are true, correct, and complete.”

Section 3.05 of the proposed revenue procedure excludes certain rental real estate arrangements from the safe harbor. Specifically, real estate used as a residence under Code § 280A for any part of the year is ineligible for the safe harbor, as is real estate rented or leased under a triple net lease.

The proposed revenue procedure is to apply for tax years ending after December 31, 2017. Until the proposed revenue procedure is published in final form, taxpayers may rely on the safe harbor. Finally, the Notice clarifies that if a rental real estate enterprise fails to satisfy the safe harbor, it may still be treated as a Code § 199A trade or business under the final regulations.