By Jackie Matsumura and Bob McGrath

The IRS released final regulations under IRC Section 199A on January 18, 2019. Along with the regulations, the IRS issued Notice 2019-07, which contains a proposed revenue procedure that provides a safe harbor for a rental real estate enterprise to determine whether it would qualify as a trade or business and, therefore, be eligible for potential tax benefits under Section 199A.   

IRC Section 199A is a significant new tax provision included in the Tax Cuts and Jobs Act (TCJA) passed in December of 2017. This complex provision allows non-corporate owners of certain businesses a deduction of up to 20 percent of domestic qualified business income from a qualified trade or business. One of the major uncertainties under Section 199A was how the provisions applied to rental activities; specifically, the determination of whether a particular rental activity rose to the level of a qualified trade or business. Consistent with the Section 199A proposed regulations issued in August of 2018, the final regulations provide that this determination is made based on prior case law. Tax practitioners and real estate industry professionals appealed to the IRS to provide clearer guidance or a bright line test for taxpayers to rely upon in complying with Section 199A. The proposed revenue procedure is a welcome development on this front. The safe harbor explained below will assist taxpayers and their advisors in determining if their real estate activities qualify for the potential benefits under Section 199A. 

A rental real estate enterprise is defined under the proposed revenue procedure as an interest in real property held for the production of rents and may consist of an interest in multiple properties. 

The individual or relevant passthrough entities (“RPE” — a partnership, S corporation, estate, or trust that is owned directly or indirectly by at least one individual, estate or trust) must hold the interest directly or through an entity disregarded as an entity separate from its owner. Taxpayers must either treat each property held for the production of rents as a separate enterprise or treat all similar properties held for the production of rents as a single enterprise. Commercial and residential real estate may not be part of the same enterprise. Taxpayers must be consistent with the treatment from year-to-year unless there has been a significant change in facts and circumstances.

A rental real estate enterprise is treated as a qualified trade or business for IRC Section 199A purposes if the following requirements are met: 

1. Separate books and records are maintained for each rental real estate enterprise 

2. At least 250 hours of rental services are performed per year (for taxable years beginning after December 31, 2022, in any 3 of the 5 consecutive taxable years) 

3. Taxpayer maintains contemporaneous records (time reports, logs, etc.) specifying: 

• hours of all services performed, 

• description of services performed, 

• dates on which such services were performed, and 

• who performed the services. 

The contemporaneous recordkeeping requirement is waived for tax years beginning before January 1, 2019. 

Rental services for purposes of the 250-hour requirement include: 

1. Advertising to rent or lease the real estate 

2. Negotiating and executing leases 

3. Verifying information in tenant applications 

4. Collection of rents 

5. Daily operation, maintenance, and repair of the property 

6. Management of property 

7. Purchase of materials 

8. Supervision of employees and independent contractors 

The rental services listed above may be performed by owners or by employees, agents and/or independent contractors of the owners. 

Rental services do not include financial or investment management activities including arranging financing, procuring property, studying and reviewing financial statements reports on operations, planning, managing or constructing long-term capital improvements, or hours spent traveling to and from the property. Real estate considered to be used by the taxpayer as a residence for personal purposes under the vacation home rules and real estate rented or leased under a triple net lease are not eligible for the safe harbor. A triple net lease for this purpose includes a lease agreement that requires the tenant or lessee to pay taxes, fees and insurance, and to be responsible for maintenance activities for a property in addition to rent and utilities. 

A taxpayer or an RPE must include a statement attached to the return on which it claims the IRC Section 199A deduction or passes through Section 199A information that the safe harbor requirements have been satisfied. The statement must be signed by the taxpayer or authorized representative who has personal knowledge of the facts and circumstances under penalties of perjury.  

A rental real estate enterprise that does not meet the safe harbor requirements may still be treated as a trade or business for 199A purposes based on facts and circumstances.   

The qualification of a rental activity or a rental real estate enterprise as a trade or business under this safe harbor is only applicable for purposes of Section 199A. Thus, for example, if the property owner is not otherwise obligated to issue Forms 1099 to contractors, such determination is unaffected by these new provisions. 

We encourage owners of rental real estate to contact their BPM advisor to discuss this new safe harbor and engage in appropriate planning to maximize the potential benefits available under Section 199A.