New IRS Safe Harbor Keeps Rental Real Estate Eligible for New Pass-Through Deduction
In December 2017, the Tax Cuts and Jobs Act created a new section to the Internal Revenue Code – Section 199A. In its simplest form, Section 199A allows owners of pass-through business entities (such as sole proprietorships, partnerships, limited liability companies, and S corporations) to deduct up to 20% of their qualified business income on their individual tax returns.
Section 199A initially appeared to be a windfall for real estate investors who own rental real estate directly or in pass-through entities. However, in August 2018, the IRS released proposed regulations to Section 199A that seemed to dispel this anticipated benefit. The proposed regulations stated that in order to qualify for the 20% deduction, a business had to be a “trade or business” as defined in Section 162(a) of the Internal Revenue Code. This set an onerous standard that many passive rental real estate investors could not meet.
On January 18, 2019, the IRS surprised the tax community by issuing a Proposed Revenue Procedure (Notice 2019-07) that creates a “safe harbor” under Section 199A. This safe harbor allows rental real estate investors to have their rental real estate activity treated as a “trade or business” for purposes of Section 199A, despite the fact that they may not meet the Section 162(a) definition.
Under the new Revenue Procedure, in order for rental real estate activity to qualify for the safe harbor, and, as a result, be treated as a trade or business for purposes of section 199A, the following requirements must be met:
- Separate books and records must be maintained to reflect income and expenses for each rental real estate enterprise;
- Each year, 250 or more hours of “rental services” must be performed with respect to the rental enterprise; and
- The taxpayer must maintain contemporaneous recordings, including time reports, logs, or similar documents regarding hours of all services performed, including descriptions of the services, dates, and who performed the services to substantiate the 250 hour requirement [Note: This is not required for 2018 tax returns].
For purposes of the second requirement of the safe harbor, rental services includes advertising to rent or lease real estate, negotiating and executing leases, verifying tenant applications, collecting rent, daily operations, maintenance, and repair, management of real estate, purchase of materials, and supervision of employees and independent contractors. Additionally, rental services may be performed by the owner, as well as employees, agents, or contractors of the owner.
There are several limitations on the proposed safe harbor, and it is important to consult with a tax professional. However, it should be noted that this safe harbor makes it much more likely for anyone who owns rental real estate to qualify for the Section 199A deduction.
If you’d like to discuss whether you qualify, or how to re-structure your holdings so that you may qualify going forward, please contact any of the attorneys in the Tax Department at Helsell Fetterman.