Section 199A Rental Safe Harbor
By Joseph Mecagni, Senior Manager, Tax & Business Services
The Tax Cut and Jobs Act, enacted in 2017, contained a new provision conveying a potential tax deduction of up to 20% on certain qualified business income. The deduction is only available to taxpayers in qualified trades or businesses. For example, a real estate owner with $200,000 of qualified business income can potentially receive a $40,000 tax deduction under new Section 199A. But does rental real estate rise to meet the definition of a qualified trade or business, allowing for this generous deduction? This article will discuss that question.
The IRS has yet to define whether rental real estate meets the qualifying definition. To help taxpayers with this uncertainty, the IRS issued Notice 2019-07, providing a safe harbor for taxpayers to follow in this circumstance.
While the safe harbor provides some clarity, however, it is limited in nature and contains some difficult hurdles that must be cleared. The IRS notice states if the taxpayer fails to satisfy the requirements of the safe harbor, the rental real estate may still be treated as a trade or business solely for the purpose of Section 199A. This this good news for taxpayers that do not meet the safe harbor.
To qualify for the safe harbor, the real estate must be owned directly or through a disregarded entity. In addition, the following requirements must be met:
- Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise.
- Annually, at least 250 or more hours of rental services are performed by or for the real estate enterprise by the owner, agent, or contractor.
- The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents that show hours of all services performed, description of all services performed, dates on which such services were performed, and who performed the services.
Rental services include:
- Advertising to rent or lease the real estate.
- Negotiating and executing lease.
- Verifying information contained in prospective tenant applications.
- Collection of rent.
- Daily operation, maintenance, and repair of the property.
- Management of the real estate.
- Purchase of materials.
- Supervision of employees and independent contractors.
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.
- Hours spent traveling to and from the real estate.
The following rental real estate arrangements are excluded from using the safe harbor:
- Real estate used by the taxpayer as a residence for any part of the year.
- Real estate rented or leased under a triple net lease. 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.
Taxpayers should easily meet the separate books and records requirement. The 250 hour test will be difficult for taxpayers owning one rental property considering only certain rental services count. For large landlords with multiple properties the 250 hour test should be an easier bar to meet. For taxpayers to maintain contemporaneous records requirement they will need a tracking system. Another log for taxpayers to maintain. If the activity does not meet the safe harbor requirements, do not worry, facts and circumstances can potentially be applied to meet the trade or business standard.
The term trade or business is used throughout the tax code, however neither the tax code or tax regulations provide a definition. The definition of a trade or business comes from common law, where the courts and case law has developed concepts and definitional requirements. In Higgins v. Commissioner, the Supreme Court noted in determining whether a trade or business exists is a factual determination. The Supreme Court in Groetzinger, 480 U.S. 23 interpreted trade or business to mean an activity conducted with continuity and regularity with the primary purpose of earning income or making a profit.
The final 199A regulations state the following relevant factors to determine if a rental real estate activity is a trade or business:
- Type of rented property (commercial real property versus residential property),
- Number of properties rented,
- Owner’s or the owner’s agents day-to-day involvement,
- Types and significance of any ancillary services provided under the lease,
- Terms of the lease (for example, a net lease versus a traditional lease and a short-term lease versus a long-term lease).
The IRS has not provided a bright line rule to determine whether a real estate activity is a trade or business. The Treasury Department and the IRS declined to adopt a position deeming all rental real estate activity to be a trade or business for purpose of section 199A. The Treasury and IRS recognize the challenges taxpayers will have in this determination, therefore it provided the safe harbor and the relevant factors above.
Trades and Business are required to prepare and file Form 1099-Misc for payments paid to service providers in excess of $600. To support a taxpayer’s position of a trade or business taxpayers need to file form 1099-Misc. There is a question on Schedule E of the taxpayers return asking if the taxpayer prepared and filed these forms. Penalties apply if the required forms are not filed.
Listening to a neighbor, relative, friend, or a pod cast could get a taxpayer into trouble as every taxpayer will have a different fact pattern. Marcum’s Real Estate Practice Group can assist real estate taxpayers evaluate the facts and circumstances to determine if the real estate activity is sufficient, continuous, and substantial enough to constitute a trade or business. Please contact your Marcum representative to start planning.