Safe Harbor Rules for Rental Real Estate

1/30/2019 - By John Mascaro, CPA

Summary

IRS issued a flurry of guidance regarding Section 199A Qualified Business Income and Deduction on Friday, January 18th. One such item was Notice 2019-07, a proposed revenue procedure that creates a safe harbor rule for treating certain rental activities as a trade or business for §199A purposes. For example, even passive shareholders/partners can still take the QBI deduction if the Relevant Passthrough Entity (RPE) itself has QBI whether it’s a rental activity or other types of operating business. Even if the rental activity was not a QBI, because, say, it was considered a Specified Service Trade or Business (SSTB), they would still get the deduction as an SSTB if their individual taxable income is below the $315,000 deduction threshold. Note that the safe harbor pertains solely to obtaining the Section 199A QBI deduction for rental real estate activities and not for any other purpose related to those activities. Where a taxpayer fails to satisfy the rental real estate safe harbor, IRS says that one might still be able to support that as a rental real estate activity is still a trade or business under other facts and circumstances, including if it meets the definition of Reg. §1.199A-1(b)(14) [i.e., a trade or business under section 162 (section 162 trade or business) other than the trade or business of performing services as an employee.]

Even though this is a proposed revenue procedure, IRS states that taxpayers may rely on this safe harbor for tax years after December 31, 2017. It issued the guidance given the uncertainty in this area for certain rental real estate taxpayers. In addition, Relevant Passthrough Entities (partnerships, S corporations, trusts, and estates, i.e., “RPEs”) may use this test as well as individuals.

Discussion

A real estate enterprise under this guidance is defined as:

Solely for purposes of this safe harbor, a rental real estate enterprise is defined as an interest in real property held for the production of rents and may consist of an interest in multiple properties. The individual or RPE relying on this revenue procedure must hold the interest directly or through an entity disregarded as an entity separate from its owner under § 301.7701-3. 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 rents (with the exception of those described in paragraph .05 of this section) 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.

For a real estate enterprise to meet the new safe harbor, three requirements must be satisfied during a taxable year as follows:

Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise;
For taxable years beginning prior to January 1, 2023, 250 or more hours of rental services are performed (as described in this revenue procedure) per year with respect to the rental enterprise. For taxable years beginning after December 31, 2022, in any three of the five consecutive taxable years that end with the taxable year (or in each year for an enterprise held for less than five years), 250 or more hours of rental services are performed (as described in this revenue procedure) per year with respect to the rental real estate enterprise; and
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 taxable years beginning prior to January 1, 2019.

In addition, rental services for purposes of the 250-hour test are defined as follows:

Rental services for purpose of this 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.

Also, certain types of rental activities will not qualify to use this safe harbor as follows:

Real estate used by the taxpayer (including an owner or beneficiary of an RPE relying on this safe harbor) as a residence for any part of the year under section 280A is not eligible for this safe harbor. Real estate rented or leased under a triple net lease is also not eligible for this safe harbor. For purposes of this revenue procedure, 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. This includes a lease agreement that requires the tenant or lessee to pay a portion of the taxes, fees, and insurance, and to be responsible for maintenance activities allocable to the portion of the property rented by the tenant.

There is an exception to the triple net lease non-QBI rule but only where the Lessor and Lessee entity are commonly controlled (more than 50% test including constructive ownership attribution) and the rental activity is considered “self-rental”.

Lastly, the taxpayer must sign and include a statement attached to the tax return in order to make use of this safe harbor:

A taxpayer or RPE must include a statement attached to the return on which it claims the section 199A deduction or passes through section 199A information that the requirements in Section 3.03 of this revenue procedure have been satisfied. The statement must be signed by the taxpayer, or an authorized representative of an eligible taxpayer or RPE, which states: “Under penalties of perjury, I (we) declare that I (we) have examined the statement, and, to the best of my (our) knowledge and belief, the statement contains all the relevant facts relating to the revenue procedure, and such facts are true, correct, and complete.” The individual or individuals who sign must have personal knowledge of the facts and circumstances related to the statement.

About the Author | John Mascaro, CPA
John is a technical director of tax research and planning in the Tax & Accounting Services Department of Saltmarsh, Cleaveland & Gund. John is adept in helping companies develop and execute complex domestic and international tax strategies. He has served some of the world’s largest companies in varied industries, including IBM, Schlumberger, Siemens; and later specialized in the entertainment and media industry. View full bio.