On January 18, 2019, the IRS published Notice 2019-07 (“Notice”), which proposed a safe harbor for when a rental real estate enterprise can be treated as a trade or business for purposes of the 20% qualified business income deduction in section 199A of the Internal Revenue Code of 1986, as amended (“Code”). After receiving and considering public comment on the Notice, the IRS, on September 24, 2019, issued Revenue Procedure 2019-38 (“Revenue Procedure”), providing for such safe harbor in final form.
II. Background on Section 199A of the Code
Section 199A of the Code was enacted by the Tax Cuts and Jobs Act of 2017. It provides a deduction of up to 20% of a non-corporate taxpayer’s qualified business income from each of the taxpayer’s trades or businesses, subject to certain limitations. For purposes of section 199A of the Code, a trade or business is defined as “any trade or business other than (A) a specified service trade or business [(“SSTB”)], or (B) the trade or business of performing services as an employee.” An SSTB is defined in Treas. Reg. § 1.199A-5(b) and the trade or business of performing services as an employee is defined in Treas. Reg. § 1.199A-5(d).
Treas. Reg. § 1.199A-1(b)(14) further defines a trade or business as “a trade or business under section 162 [of the Code] . . . other than the trade or business of performing services as an employee.” Additionally, this regulation provides that “rental activity that does not rise to the level of a section 162 trade or business is nevertheless treated as a trade or business for purposes of section 199A [of the Code], if the property is rented or licensed to a trade or business conducted by the individual or a [relevant passthrough entity (“RPE”)] which is commonly controlled under [Treas. Reg.] § 1.199A–4(b)(1)(i) . . . .”
A rental real estate enterprise may be treated as a trade or business for purposes of section 199A of the Code if it satisfies either the safe harbor in the Revenue Procedure or if it otherwise meets the definition of a trade or business in Treas. Reg. § 1.199A-1(b)(14). The Revenue Procedure applies to tax years after December 31, 2017, though taxpayers may rely on the safe harbor in the Notice for tax year 2018.
III. Requirements Under the Revenue Procedure
A. Rental Real Estate Enterprise
The safe harbor may be used by taxpayers who want to claim the deduction under section 199A of the Code with respect to a rental real estate enterprise, which is defined in the Revenue Procedure as “an interest in real property held for the production of rents and may consist of an interest in a single property or interests in multiple properties.” The safe harbor may also be used by RPEs, which are defined in Treas. Reg. § 1.199A-1(b)(10).
The taxpayer or RPE must hold each interest either directly or through a disregarded entity. Each interest in similar property may be treated as a separate rental real estate enterprise or interests in all similar properties may be treated as a single rental real estate enterprise. Properties are similar if they are a part of the same category, i.e., they are either all residential or all commercial.
Once interests in similar properties are treated as a single rental real estate enterprise, then the interests in the similar properties, including newly acquired properties, must continue to be treated as such for as long as the safe harbor is being used. However, if a taxpayer or RPE chooses to treat each of its interests in similar property as a separate rental real estate enterprise, then such taxpayer or RPE may later elect to treat its interests in all similar properties as a single rental real estate enterprise in a future year. Under the proposed safe harbor in the Notice, taxpayers would not have been able to vary their treatment from year to year unless there had been a significant change in facts and circumstances.
An interest in mixed-use property, i.e., a single building that combines residential and commercial units, may be treated as a single rental real estate enterprise or may be bifurcated into separate residential and commercial interests. If treated as a single rental real estate enterprise, the interest in the mixed-use property may not be treated as part of the same enterprise as any other residential, commercial or mixed-use property. Mixed-use property was not previously addressed in the Notice.
B. Specific Safe Harbor Requirements
The determination to use the safe harbor is made on an annual basis. Each rental real estate enterprise that satisfies the following requirements for the taxable year will be treated as a single trade or business for purposes of applying section 199A of the Code and its regulations:
“(A) Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise . . . ;
(B) For rental real estate enterprises that have been in existence less than four years, 250 or more hours of rental services are performed . . . per year with respect to the rental real estate enterprise. For rental real estate enterprises that have been in existence for at least four years, in any three of the five consecutive taxable years that end with the taxable year, 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 . . . .
(D) The taxpayer or RPE attaches a statement to a timely filed original return (or an amended return for the 2018 taxable year only) for each taxable year in which the taxpayer or RPE relies on the safe harbor. . . .”
The statement required by Part (D) above must include descriptive information concerning certain rental real estate properties and the rental real estate enterprise(s) for which the deduction is sought, as well as a statement that the requirements of the Revenue Procedure have been satisfied. The descriptive information required under Part (D) is a new requirement under the Revenue Procedure that was not provided for in the Notice. Instead, the Notice provided only that a statement must be signed under penalties of perjury and attached to the return on which the deduction is being claimed that demonstrates that the requirements of the Notice have been satisfied.
The Revenue Procedure includes examples of what will (and will not) be considered “rental services” referenced in Part (B) above. Rental services may be performed by owners, or by employees, agents and/or independent contractors of the owners.
Additionally, the Revenue Procedure provides that the contemporaneous records requirement of Part (C) will not apply to taxable years beginning prior to January 1, 2020.
Section 3.05 of the Revenue Procedure excludes the following rental real estate arrangements from being eligible for the safe harbor:
(1) Real estate used as a residence by the taxpayer (or by an owner or beneficiary of an RPE).
(2) Real estate rented or leased under a triple net lease, which the Revenue Procedure describes as including “a lease agreement that requires the tenant or lessee to pay taxes, fees, and insurance, and to pay for maintenance activities for a property in addition to rent and utilities.”
(3) Real estate rented to a trade or business conducted by a taxpayer or an RPE which is commonly controlled under the rules of Treas. Reg. § 1.199A-4(b)(1)(i).
(4) The entire rental real estate interest if any portion of the interest is treated as an SSTB under Treas. Reg. § 1.199A-5(c)(2).
Items (3) and (4) above are new additions to the Revenue Procedure. The Notice provided only for Items (1) and (2), though the exclusion list for either the Revenue Procedure or the Notice is not exhaustive.
Although uncertainties remain in the application of section 199A rules, with the issuance of the Revenue Procedure, taxpayers and RPEs now have a safe harbor to rely upon when determining whether a rental real estate enterprise can be treated as a trade or business for purposes of the 20% qualified business income deduction.