Ever since tax reform was passed over a year ago, taxpayers have been uncertain whether rental property will be classified as a trade or business for purposes of qualifying for the new IRC Sec 199A 20% pass-through deduction (commonly referred to as the 199A deduction).
Finally, on January 18, 2019, the IRS issued a notice which provided “safe harbor” conditions under which a rental real estate activity will be treated as a trade or business for purposes of the 199A deduction.
It’s important to note that this notice prescribes several conditions that must be met for a rental real estate enterprise (a tax term introduced by the IRS in this notice) to be deemed to be a trade or business and eligible for the section 199A 20% deduction. For purposes of this safe harbor, 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.
Failure of the taxpayer to satisfy the requirements of this safe harbor does not preclude a taxpayer from otherwise establishing that a “rental real estate enterprise” is a trade or business for purposes of section 199A. The following are the requirements that must be satisfied for the safe harbor:
- Separate books and records must be maintained for each rental real estate enterprise;
a. A real estate enterprise can consist of a single or multiple real estate rentals.
b. Commercial and residential rentals cannot be combined in the same real estate enterprise.
- For years prior to 2023, at least 250 hours of rental services must be performed by the taxpayer and workers for the taxpayer for the year in question with reference to each rental real estate enterprise.
A three-year lookback rule applies for taxable years for 2023 and following. It specifies that the taxpayer must meet the 250-hour requirement for the rental enterprise for any three of the five prior consecutive taxable years; and
- The taxpayer must maintain contemporaneous records, including time reports, logs, or similar documents, to document the following:
a. hours of all services performed;
b. a description of all services performed;
c. dates on which such services were performed; and
d. who performed the services.Because the safe harbor requirements were issued after the close of 2018, the requirement for contemporaneous records for 2018 will not apply.
Rental services that may be counted toward the 250 hour requirement include: (i) advertising to rent or lease the real estate; (ii) negotiating and executing leases; (iii) verifying information contained in tenant applications; (iv) collecting rent; (v) daily operation, maintenance, and repair of the property; (vi) management of the real estate; (vii) purchase of materials for operation such as repairs; and (viii) supervision of employees and independent contractors.
However, rental services do NOT include financial or investment management activities, such as arranging financing; procuring property; studying and reviewing financial statements or reports on operations, planning, managing, or constructing long-term capital improvements; or hours spent traveling to and from the real estate.
Rental services counted toward the 250 requirement may be performed by owners or employees, agents, and/or independent contractors working for the owners.
Triple net Leases are not eligible for safe harbor. Real estate rented or leased under a triple net lease agreement is not eligible for this safe harbor. A triple net lease 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. Also ineligible for the safe harbor is a property leased under an agreement that requires the tenant or lessee to pay a portion of the taxes, fees, and insurance, and to be responsible for maintenance activities allocable to the portion of the property rented by the tenant.
Vacation rentals are not eligible for safe harbor. Real estate used as a residence by the taxpayer for any portion of the taxable year is not eligible for the safe harbor rules.
The Statement must be attached to the tax return. A statement signed by the taxpayer, or the person responsible for keeping the records with personal knowledge of them, must be attached to the return declaring that all of the safe harbor requirements have been met and must include the following language: “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.”
Double-edged sword. The 199A deduction is 20% of a taxpayer’s qualified business income from all of the taxpayer’s trades or businesses subject to certain limitations. Many rentals do not show a profit and a rental that is treated as a trade or business that shows a loss for the year will reduce the qualified business income of other trades or businesses of an individual, and as a result, reduces the 199A deduction of that individual.
If you have questions regarding rentals as a trade or business or other issues related to this new 199A deduction, please call us to schedule a consultation.