When proposed regulations under new Section 199A were issued regarding the deduction for pass-through entities, many real estate professionals were frustrated by the use of Section 162 to define a “trade or business” eligible for the deduction, as application of this standard to the real estate industry historically has been murky. Although the recently issued final regulations retain the Section 162 standard, the IRS concurrently issued Notice 2019-07, which describes a safe harbor under which a rental real estate enterprise will be treated as a trade or business eligible for the pass-through deduction.
The Pass-Through Deduction
Section 199A, introduced as part of the Tax Cuts and Jobs Act, generally permits a deduction for up to 20 percent of qualified business income from pass-through entities and up to 20 percent of real estate investment trust dividends and publicly traded partnership income. Under the final regulations, the determination of whether rental real estate is a qualified business will be based on facts and circumstances, including the type of rental property, number of properties rented, owner’s or agent’s day-to-day involvement, and lease terms. Although the notice describes a safe harbor allowing a real estate rental business to qualify under Section 199A, taxpayers may still satisfy the requirements based on overall facts and circumstances.
Safe Harbor Requirements: 250 or More Hours of Documented Rental Services
There are three basic components of the safe harbor: (1) maintain separate books and records for each real estate business, (2) perform 250 or more hours of rental services per year with respect to the business, and (3) maintain contemporaneous records regarding such services.
- Employees, agents, or independent contractors may perform rental services. Such services include advertising, lease negotiations, and review of tenant applications. Investment management activities such as arranging financing, procuring property, studying financial statements, managing capital improvements, or hours spent traveling to and from the real estate do not qualify as rental services.
- For tax years beginning after Jan. 1, 2023, taxpayers may qualify if the 250-hour requirement is satisfied in any three of the previous five tax years.
- Although the safe harbor applies to tax years ending after Dec. 31, 2017, the contemporaneous documentation requirement does not apply for 2018.
The safe harbor cannot be applied to rental of a taxpayer’s personal residence or to triple net leases. In addition, taxpayers cannot elect in and out of the safe harbor without a significant change in facts and circumstances of the real estate enterprise. However, because taxpayers have the option to combine similar properties (other than commercial and residential properties, which may not be combined) or treat each property as a separate business, careful analysis may permit taxpayers to maximize the benefits of the safe harbor.