If you invest in rental real estate or are considering it, the IRS has provided guidance to those seeking to take advantage of the new Section 199A “pass-through” deduction. Notice 2019-07 establishes a safe harbor under which qualifying rental real estate enterprises will be treated as a “trade or business” eligible for the deduction.
Sec. 199A allows individual taxpayers to deduct up to 20% of their qualified business income from a qualified trade or business operated directly or through a pass-through entity (such as a partnership, S corporation or LLC). The deduction is subject to several restrictions and limitations.
Unfortunately, many rental real estate owners were uncertain whether their activities rose to the level of a trade or business for purposes of the deduction. The notice is designed to mitigate this uncertainty for owners who satisfy the safe harbor’s requirements.
What are the requirements?
To qualify for the safe harbor, a rental real estate enterprise—which may consist of multiple properties—must meet these requirements:
- Separate books and records are maintained for each rental real estate enterprise.
- A total of 250 or more hours of rental services are performed per year with respect to the enterprise, either by its owners or their employees, agents or independent contractors. (For tax years beginning after 2022, this requirement may be satisfied if 250 or more hours of rental services are performed in any three of the most recent five years.)
- The taxpayer maintains contemporaneous time reports and other records showing the hours and dates of all services performed, a description of the services, and who performed them.
Rental services include advertising property for rent or lease; negotiating and executing leases; verifying tenant applications; and collecting rent. They also include conducting daily operations, maintenance or repairs; managing property; purchasing materials; and supervising employees and contractors.
The services don’tinclude financial or investment management services, such as arranging financing; procuring property; or reviewing financial statements or operating reports. Nor do they include planning, managing or constructing long-term capital improvements, or spending time traveling to and from the property.
Two types of real estate are ineligible for the safe harbor: 1) real estate used by the taxpayer (including an owner or beneficiary of a relevant pass-through entity) as a residence for any part of the year, or 2) real estate covered by a triple net lease (one that requires the tenant to pay taxes, fees and insurance on, and to be responsible for maintenance of, the leased property).
What if you don’t qualify?
If you don’t meet all the safe harbor’s requirements, you may still be eligible for the Sec. 199A deduction. That’s if you can show that your enterprise otherwise meets the general definition of “trade or business.” To do so, you’ll need to review the various factors considered by the IRS and the courts in determining whether real estate activities rise to the level of a trade or business. The factors include the type and number of properties, the extent of the owner’s involvement, and the lease terms.
The notice contains a proposed revenue procedure outlining the safe harbor requirements. It’s possible that the safe harbor will be modified, but the notice states that it can be relied upon until the revenue procedure is finalized.
This has been for general information only and is not intended as specific advice. Tax matters can be complex, so consider getting professional help before making decisions.
Norman G. Grill, CPA, (N.Grill@GRILL1.com) is managing partner of Grill & Partners, LLC, (www.GRILL1.com) certified public accountants and advisors to closely held companies and high-net-worth individuals, with offices in Fairfield and Darien, 203 254.3880.