Safe harbor for real estate as a trade or business under Sec 199a (the “pass through” deduction)
Much attention has been drawn to a specific aspect of the Tax Cuts and Jobs Act, President Trump’s landmark tax legislation that affects 2018 tax returns. The so called “pass through” deduction (technically section 199a) provides up to a 20% deduction to non-corporate taxpayers on their business income. Interestingly enough, rental real estate enterprises were included as eligible businesses for this deduction, even if historically rental activities have been viewed as passive income for tax purposes. There has been much speculation as to when a rental activity would be eligible for this deduction, and recently the IRS released proposed guidance (Notice 2019-7) which gives a safe harbor for treating rental real estate as a trade or business solely for purposes of the Section 199A deduction.
The term enterprise is a defined as an interest in real property held for the production of rents and may consist of an interest in multiple properties. 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 as a single enterprise. Commercial and residential real estate may not be part of the same enterprise. Taxpayers may not vary this treatment from year-to-year unless there has been a significant change in facts and circumstances. This enterprise grouping is solely for purposes of the Section 199A deduction and does not affect other groupings of rental activities as it relates to the passive loss activity rules.
To satisfy the safe harbor, the IRS has proposed that a rental real estate enterprise will be a trade or business if:”
- Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise
- For tax years beginning prior to Jan. 1, 2023, 250 or more hours of rental services are performed (as described below) per year with respect to the rental enterprise. For tax years beginning after Dec. 1, 2022, in any three of the five consecutive tax years that end with the tax 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
- 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. Such records are to be made available for inspection at the request of the IRS. The contemporaneous records requirement will not apply to tax years beginning prior to Jan. 1, 2019.
Rental services for purpose of the proposed revenue procedure include: (i) advertising to rent or lease the real estate; (ii) negotiating and executing leases; (iii) verifying information contained in prospective tenant applications; (iv) collection of rent; (v) daily operation, maintenance, and repair of the property; (vi) management of the real estate; (vii) purchase of materials; and (viii) supervision of employees and independent contractors. Rental services may be performed by owners or by employees, agents, and/or independent contractors of the owners. The term rental services does 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.
Since each taxpayer’s situation is different, the application of this ruling will vary. Please contact us for how this ruling may affect your specific situation. Follow us on Twitter and Facebook to stay up-to-date on tax developments and updates!