One of the urgent issues that taxpayers have been struggling with under the Tax Cuts and Jobs Act (the "Act") is what rental real estate activities will qualify for the 20% deduction for qualified business income ("QBI") under Section 199A of the Internal Revenue Code (the “Code”). The Section 199A requirements for claiming the deduction leave doubt as to whether certain real estate activities qualify. On January 18, 2019, the Internal Revenue Service (IRS) sought to address this by issuing Notice 2019-07, which contains a proposed revenue procedure outlining a safe harbor for determining whether the rental real estate enterprise is a trade or business. Taxpayers may rely on the proposed safe harbor until it is finalized. Although taxpayers have generally welcomed clarification of this issue, many are disappointed that property that is triple-net-leased cannot qualify for the safe harbor. For more information on these exclusions and other aspects of Code Section 199A, please stay tuned for our subsequent alert, which will be published shortly, on the Code Section 199A final regulations that were released simultaneously with Notice 2019-07.
Subject to several limitations, Code Section 199A allows non-corporate taxpayers to deduct up to 20% of their QBI from a domestic business operated as a sole proprietorship, partnership (including a limited liability company taxed as a partnership), S corporation, trust, or estate. To claim the deduction, the taxpayer must have income from a qualified trade or business. For this purpose, a qualified trade or business is defined as any trade or business under Code Section 162, other than certain specified service trades or businesses or the trade or business of performing services as an employee.
Under existing law, however, it is not always clear whether a rental real estate enterprise is a trade or business. Notice 2019-07 is intended to mitigate some of this uncertainty by providing a safe harbor under which rental real estate activities will be treated as a trade or business.
Safe Harbor Requirements
A rental real estate enterprise will be treated as a trade or business under Code Section 199A if it satisfies the criteria outlined in the safe harbor. Failure to qualify as a trade or business under the safe harbor, however, does not preclude a taxpayer from otherwise establishing that its rental real estate enterprise is a trade or business.
The safe harbor applies to "rental real estate enterprises," which is defined as an interest in real property held for the production of rents and may consist of multiple properties. To qualify, the taxpayer must hold its interest in the rental real estate enterprise either directly or through a disregarded entity. Taxpayers must either treat each property held for the production of rental income as a separate enterprise or treat all similar properties held for the production of rental income as a single enterprise. Taxpayers cannot treat commercial and residential real estate as part of the same enterprise. Moreover, taxpayers cannot vary this treatment year-to-year unless there has been a significant change in the taxpayer’s facts and circumstances.
The safe harbor provides that, for purposes of Code Section 199A, a rental real estate enterprise will be treated as a trade or business if it satisfies the following criteria:
- The taxpayer maintains separate books and records to reflect income and expenses for each rental real estate enterprise;
- 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
- 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 taxpayer must make such records available for inspection at the request of the IRS. The contemporaneous-records requirement will not apply to taxable years beginning prior to January 1, 2019.
Certain rental real estate activities are specifically excluded from qualifying for the safe harbor. Real estate rented or leased under a triple net lease is not eligible. For these purposes, a triple net lease is where the tenant is responsible for paying taxes, fees, and insurance as well as maintenance activities for a property in addition to rent and utilities. Also ineligible for the safe harbor is rental real estate used by the taxpayer as a personal residence for more than 14 days during the year under Code Section 280A.
Rental services for purposes of the hours requirement of the safe harbor include:
- advertising to rent or lease the real estate
- collection of rent
- daily operation, maintenance, and repair of the property
- management of the real estate
- supervision of employees and independent contractors.
Rental services performed by employees, agents, and contractors of the owners all count toward the hours requirement. Financial or investment management activities, such as arranging financing or studying and reviewing financial statements, or hours spent traveling to and from the real estate, do not count toward the hours requirement.
To elect trade or business status under the safe harbor, the taxpayer or pass-through entity must attach a signed statement to the tax return on which it claims the Section 199A deduction that the safe harbor requirements have been satisfied.
To the degree that it mitigates uncertainty regarding the types of rental real estate activities that qualify for purposes of the Code Section 199A deduction, the safe harbor is helpful. Given the uncertainty regarding whether a triple net lease qualifies as a trade or business, exclusion of triple net leased property from the safe harbor is not surprising. Further clarification regarding the treatment of triple net leases under Code Section 199A would be very helpful to the many taxpayers who use them. However, given that the IRS has repeatedly stated that it does not intend to use guidance under Section 199A to clarify the definition of what constitutes a trade or business under the Code, such clarification might not be forthcoming.