The IRS recently clarified the terms under which rental real estate owners can qualify for a new tax break under section 199A of the Internal Revenue Code.
The section provides a tax deduction of up to 20 percent of an entity’s qualified business income, or QBI, for many owners of pass-through entities, including sole proprietorships, partnerships and S corporations. (QBI is defined as the net amount of qualified items of income, gain, deduction and loss from any qualified “trade or business,” but the law does not include a clear rule defining what constitutes a “trade or business.”)
For rental real estate owners, it had been unclear whether they were eligible for the deduction. The IRS initially released Notice 2019-07 proposing a “safe harbor” that determines when rental real estate would be defined as a “trade or business” to qualify for the deduction.
The new Revenue Procedure finalizes the safe harbor, with a few changes. It defines the safe harbor, but states that a taxpayer who finds the requirements too complicated to satisfy could use other information to establish they qualify for the deduction under general tax principles.
The safe harbor applies for tax years ending after Dec. 31, 2017.
The safe harbor is available to taxpayers and relevant pass-through entities seeking to claim the deduction under section 199A with respect to a “rental real estate enterprise.” It states that a “rental real estate enterprise” is an interest in real property held to generate rental or lease income.
Under the safe harbor, the following conditions must be met for a rental real estate enterprise to satisfy the trade or business requirements under section 199A:
- separate books and records must be maintained to reflect income and expenses for each rental real estate enterprise;
- for rental real estate enterprises that have been in existence for less than four years, 250 or more hours of rental services must be performed per year. For rental real estate enterprises that have been in existence for four years or more, 250 or more hours of “rental services” must have been performed in at least three of the past five years. “Rental services” specifically 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, including the purchase of materials and supplies; (vi) management of the real estate; and (vii) supervision of employees and independent contractors;
- the taxpayer must maintain contemporaneous records regarding the services performed. That includes a description of the services, the dates on which such services were performed, the identity of the person who performed the services and the total hours spent performing the services. The contemporaneous records requirement applies to tax years beginning on or after Jan. 1, 2020;
- the taxpayer or relevant pass-through entity must attach a statement to its tax return filed for the tax year(s) for which the taxpayer relies upon the safe harbor, specifically representing that the requirements of the IRS Revenue Procedure have been met.
Rental services hours
Many entities that commented on the proposal urged the IRS to reduce the number of rental services hours required under the safe harbor, but the IRS left it at 250 hours. The challenge of this requirement is reduced because the rule allows services of both employees and independent contractors to satisfy the requirement.
However, that requires some owners of rental real estate to adjust their practices to ensure detailed invoicing with service providers, especially because employees and independent contractors do not always report the number of hours they spend servicing a property.
Under the proposed definition of the safe harbor, it was unclear if mixed-use properties were eligible for the deduction under section 199A. The final version states that an interest in mixed-use property may be treated in one of two ways: 1) as a single rental real estate enterprise, or 2) bifurcated into separate residential and commercial interests.
The Revenue Procedure defines “mixed-use property” as a single building that combines residential and commercial units.
While it is favorable for mixed-use properties to be eligible for the tax break, it does require owners to review their properties and decide the best way to categorize them. That is especially true because separate record-keeping would also be required.
A real estate attorney can help you evaluate the best way to categorize your rental properties.
Property under triple net lease not eligible
Property under a triple net lease is not eligible for the safe harbor, but an owner can still establish that the property meets the “trade or business” requirements to get the tax break.
Under the Revenue Procedure, a triple net lease is defined as a lease agreement that requires the tenant or lessee to pay taxes, fees and insurance, and to be responsible for property maintenance in addition to rent and utilities.