Tax and financial advice from the Silicon Valley expert.

IRS issues Safe Harbor for rental real estate qualification for 20% qualified business income deduction

One of the most controversial items in the Tax Cuts and Jobs Act of 2017, enacted during December, 2017, is whether rental real estate qualifies as a trade or business, and therefore qualifies for the 20% deduction for qualified domestic business income under Internal Revenue Code Section 199A.

Late January, 2019, the IRS issued Notice 2019-07.  The Notice is a proposed Revenue Procedure that outlines a safe harbor for rental real estate operations to qualify as a trade or business and qualification for the 20% of qualified domestic business income deduction under Internal Revenue Code Section 199A.

The Revenue Procedure is proposed to be effective for taxable years ending after December 31, 2017.

The advantage of following the Revenue Procedure is avoiding a dispute and possible litigation with the IRS about whether a rental real estate operation qualifies for the deduction.

Under the Revenue Procedure, a rental real estate enterprise must meet a series of requirements.

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 as a single enterprise.  Commercial and residential real estate may not be part of the same enterprise.  Taxpayers must report their real estate operations consistently from year-to-year unless there has been a significant change in facts and circumstances, such as acquiring another property.

Here are the requirements to be met.

  1. Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise.
  2. For taxable years beginning before January 1, 2023, 250 or more hours of rental services are performed each year with respect to the rental enterprise.  For taxable years beginning after December 31, 2022, the test must be met in any three of the five consecutive taxable years that end with the taxable year.
  3. The taxpayer must maintain contemporaneous records, including time reports, logs, or similar documents regarding (i) hours of all services performed; (ii) description of services performed; (iii) dates on which such services were performed; and (iv) who performed the services.  The records are to be made available for inspection at the request of the IRS.  This requirement doesn’t apply for taxable years beginning before January 1, 2019.

Rental services 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, buying property, studying and reviewing financial statements or operations reports, or planning, managing or constructing long-term capital improvements, or hours spent traveling to and from the real estate.

Rental real estate rented or leased under a triple-net lease requiring 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.

(Remember that, under the final Section 199A regulations, property rented to a commonly-controlled entity is considered to be the same type of business income as the entity it is rented to, even for a triple-net lease.)

Real estate used by the taxpayer (including an owner or beneficiary of a relevant passthrough entity relying on the safe harbor) also doesn’t qualify for the safe harbor.

The taxpayer or relevant passthrough entity must attach a statement to the tax return on which it claims the Section 199A deduction or passes through Section 199A information that the requirements of the Revenue Procedure are satisfied.  The statement must be signed by the taxpayer or an authorized representative of an eligible taxpayer or relevant passthrough entity.  Here is the required wording of the statement. “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.

The Revenue Procedure only gives a safe harbor to qualify for the 20% of qualified domestic business income deduction.  Taxpayers may still claim they qualify under a different standard.  (These are excerpts of an analysis by Gary McBride, CPA and attorney.)

The IRS is generously applying a service-based standard in the Revenue Procedure.  Another standard has also been applied to determine that rental real estate operations are a trade or business.

The IRS’s position is based on a decision of the Second Circuit Court of Appeals, Grier v. U.S., 218 F. 2d 603, 2nd Cir., 1955.)  This position is only followed by the Tax Court in the Second Circuit.  Under the Grier decision, it is highly unlikely the rental of one single family residence can be a trade or business for taxpayers located in the Second Circuit Court of Appeals territory.

In other cases, the courts have looked to whether the taxpayer was responsible for the maintenance of the property.  (Hazard v. Commissioner, 7 TC 372 (1946) acq. 1946-2 CB 3; Reiner v. US, 22 Fd. 2nd. 770 7th Circ., 1955).)  In GCM 38779 (7/27/81), the IRS Chief Counsel rejected an IRS national office audit group request to remove the acquiescence to Hazard.

If it is practical, I recommend that you follow the safe harbor in the Revenue Procedure to avoid having an IRS controversy.

You might find it challenging to get the time accounting records from independent contractors who perform services for you.  You should have an understanding with them about the requirements before the work is done.

I hope it is apparent to our readers that you should get help with a professional tax advisor when applying these rules.

Amended 2017 returns required for fiscal year passthrough entities

Since proposed regulations were not issued for owner/beneficiary information relating to the 20% of qualified business income deduction until August 8, 2018 and it wasn’t listed on the 2017 forms, that information was omitted on many passthrough entity income tax returns for fiscal years ending in 2018.  According to proposed regulations issued on August 8, 2018, that information should be included on the 2018 income tax returns for the owner.  (Proposed Regulations Sections 1.199A-1(f)(2) and 1.643(e)-(2)(ii).)  If that information is listed on the owner’s Schedule K-1, it’s presumed to be zero.  (Proposed Regulations Section 1.199A-6(b)(3)(iii).)

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Tax and financial advice from the Silicon Valley expert.