IRS Finalizes Section 199A Safe Harbor for Rental Real Estate; Triple Net Leases Excluded
CSG Tax Law Alert
On Tuesday, September 24, 2019, the Treasury Department (“Treasury”) and the Internal Revenue Service (“IRS”) issued Revenue Procedure 2019-38 (“Rev. Proc. 2019-38”), which finalizes a safe harbor for rental property under Section 199A of the Internal Revenue Code of 1986, as amended (the “Code”). The safe harbor was originally set forth in IRS Notice 2019-07, 2019-09 IRB 740. The determination to use the safe harbor must be made annually.
If all the safe harbor requirements are met, an interest in rental real estate will be treated as a trade or business for purposes of Section 199A and thus will be eligible for the qualified business income deduction (the “QBI Deduction”) under Section 199A, even if it does not meet the literal definition of a “trade or business” set forth in Treas. Reg. Section 1.199-1(b)(14). This safe harbor is available for taxpayers who seek to claim the QBI Deduction with respect to a “rental real estate enterprise.”
By way of background, Section 199A was enacted as part of the Tax Cuts and Jobs Act of 2017 to provide a deduction to non-corporate taxpayers of up to twenty percent (20%) of the taxpayer’s qualified business income from each of the taxpayer’s qualified trades or businesses, including those operated through a partnership, S corporation, or sole proprietorship, as well as a deduction of up to twenty percent (20%) of aggregate real estate investment trust dividends and qualified publicly traded partnership income. Following the issuance of Section 199A, a level of uncertainty emerged regarding whether an interest in rental real estate rises to the level of a trade or business for purposes of the QBI Deduction, stemming from the fact that the Section 199A treasury regulations generally adopted a facts and circumstances trade or business test under Code Section 162. The safe harbor in Rev. Proc. 2019-38 (and Notice 2019-07) now answers the question.
The safe harbor permits a rental real estate enterprise (defined as an interest in real property held for the production of rents, which may consist of an interest in a single property or interests in multiple properties) to be treated as a single Section 199A trade or business if sufficient “rental services” were performed for the enterprise.
There are two types of rental real estate categories for purposes of combining properties into a single rental real estate enterprise: residential and commercial. Generally, residential properties can only be combined with other residential properties, and commercial properties can only be combined with other commercial properties. Mixed-use properties may qualify as a single rental real estate enterprise if certain requirements are met. Specific rules apply once a taxpayer treats interests in similar properties as a single rental real estate enterprise under the safe harbor. For example, once entities are combined into a single rental real estate enterprise, all similar properties (including newly acquired properties) must remain combined when relying on the safe harbor.
The term “rental services” means: (i) advertising to rent or lease the real estate; (ii) negotiating and executing leases; (iii) verifying information contained in prospective tenant applications; (iv) collecting rent; (v) operating, maintaining and repairing properties on a daily basis; (vi) managing real estate; (vii) purchasing materials; and (viii) supervising employees and independent contractors. Importantly, these services may be performed by the owner of the enterprise, employees, or independent contractors. The term “rental services” does not include financial or investment management activities, procuring property, reviewing financial statements or reports on operations, property improvements that require capitalization under Section 263A, or hours spent travelling to and from the real estate at issue.
The IRS explains that a rental real estate enterprise will be treated as a single trade or business if: (1) separate books and records are maintained to reflect income and expenses for each enterprise; (2) for enterprises in existence less than four (4) years, 250 or more hours of rental services are performed per year (for enterprises in existence for at least four (4) years, that requirement must only be met for three (3) out of the past five (5) years); (3) taxpayer maintains contemporaneous records on hours of services performed, description of services, dates of services, and who performed such services; and (4) taxpayer attaches a statement with information such as a description of the properties, to a timely filed original return for each year in which the enterprise relies on the safe harbor.
The safe harbor is not available to: (i) real estate used by the taxpayer as a residence under Section 280A(d); (ii) real estate rented or leased under a triple net lease; (iii) real estate rented to a trade or business conducted by a taxpayer or a relevant pass-through entity commonly controlled under Treas. Reg. 1.199A-4(b)(1)(i); and (iv) the entire rental real estate interest if any portion of the interest is treated as a “specified service trade or business” under § 1.199A-5(c)(2). For purposes of Rev. Proc. 2019-38, a triple net lease includes a lease agreement that requires the tenant or lessee to pay taxes, fees, and insurance, and to pay for maintenance activities for a property in addition to rent and utilities. The exclusion of real estate rented or leased under a triple net lease from the safe harbor remains despite hopes that the restriction on triple net leases would be loosened.
Rev. Proc. 2019-38 applies to taxable years ending after December 31, 2017, but taxpayers may rely on the safe harbor set forth in Notice 2019-07, for the 2018 taxable year. The contemporaneous records requirement will not apply to taxable years beginning prior to January 1, 2020; however, taxpayers are reminded that they bear the burden of showing the right to any claimed deductions in all taxable years.
Comments on the Rev. Proc. 2019-38 are due by December 16, 2019.
For more information, please contact your CSG attorney or the authors listed below.