On January 18, 2019, final regulations were issued relating to IRC Section 199A, the “20% pass-through deduction”, to help clarify the circumstances in which this deduction will be allowed for taxpayers who own rental real estate.
A taxpayer’s eligibility for this deduction is first determined by whether the activity qualifies as a Section 162 Trade or Business, a term of art for tax professionals. Determining whether rental real estate activity is a trade or business has been challenging. Historically, case law and each taxpayer’s facts and circumstances are what drives whether a rental real estate activity is a trade or business. In an effort to provide guidance to taxpayers on this issue, the IRS issued Revenue Procedure 2019-7. This procedure contains a safe harbor provision where if certain qualifications are met, rental real estate will qualify as a Section 162 trade or business activity.
Furthermore, beginning January 1, 2019, and thereafter in order to qualify as a trade or business under the safe harbor rules, the taxpayer must maintain separate books and records for each rental activity (or combined if rental activities are grouped as one), spend 250 hours or more on rental services, and maintain contemporaneous records, including time reports or logs, detailing the following:
- Description of all services performed
- Hours spent on all services performed
- Dates of service
- Who performed the services
The 250 hours of rental services may include time spent on advertising, negotiating leases, daily operations, maintenance, collection of rent, management, and supervision of employees, among others. These hours can be performed by the property owners, employees, or independent contractors and/or agents. Note that investment hours do not count as rental services. This includes activities spent on obtaining financing for the property, reviewing financial statements, and hours spent managing capital improvements. Furthermore, travel to and from the property are also not considered rental services.
It is also important to note that a taxpayer cannot use the safe harbor for any property leased on a triple net basis. A triple net lease is one where a landlord passes on the responsibility for the payment of taxes, insurance and maintenance (Section 162 expenses) to the tenant. To qualify as trade or business, and not be deemed a triple net lease, the landlord must be responsible for the section 162 expenses. Additionally, the safe harbor is not available for property that the taxpayer uses as a personal residence for more than 14 days during the year, such as a vacation home.
If a taxpayer does not meet the requirements of this safe harbor provision, their rental activity may still qualify as a trade or business, based upon the facts and circumstances or if the lease (including a triple-net lease) is between a partnership, LLC or S Corporation, where there is common ownership between the operating business and the rental entity. This is considered self-rental and is an exception to the trade or business requirements outlined.
Navigating these regulations and determining whether a taxpayer may benefit from the Section 199A pass-through deduction is a complicated issue. Working with a tax professional that specializes in the real estate sector may be advisable given the complexity of these new rules.