Article written by:
Azra Nakicevic, CPA
Director, Tax & Business Advisory Services
Recently issued final regulations on the Section 199A deduction, also known as the pass-through deduction or 20% deduction, provided some much-needed guidance and explanations related to qualification, calculation, and reporting rules for the Section 199A deduction. While many of the questions were answered with the final set of regulations, uncertainty still exists in other areas, with new questions emerging that are bound to cause headaches to taxpayers and their advisors as they navigate the new law. One of those uncertainties is whether or not rental property activity can be treated as a trade or business eligible for the pass-through deduction.
As a general rule, Section 199A created significant tax benefits for many taxpayers in the real estate industry. Real estate brokers and agents who are not employees, but operate as sole proprietors or owners of partnerships or S corporations, are eligible for the new 20% deduction. Real estate management businesses also qualify for the new tax benefit. The deduction may be limited for high-income taxpayers to the greater of (a) 50% of W-2 wages paid by the business or (b) 25% of wages plus 2.5% of the cost of depreciable property. Many rental real estate entities do not have employees, but instead, pay a management fee to a management company which is not considered W-2 wages for Section 199A. By allowing taxpayers to use the cost of depreciable property for Section 199A limitation calculations, rental real estate properties were given an ‘in’ on Section 199 deduction.
However, to benefit from Section 199A deduction, real estate rentals need to rise to the level of trade or business under Section 162. There has been very little guidance and case history governing what constitutes trade or business under Section 162, and in particular, whether or not rental real estate raises to the level of trade or business.
To help rental real estate businesses cope with the trade or business issue, the IRS released Notice 2019-07 along with final Section 199A regulations. The Notice provides a safe harbor under which a ‘rental real estate enterprise’ will be treated as a trade or business for Section 199A purposes, provided certain requirements are met. The safe harbor applies to both individuals and pass-through entities. Rental real estate enterprise may consist of an interest in multiple properties owned by the taxpayer, but each enterprise may only include similar types of properties. As such, commercial and residential real estate may not be combined into one rental real estate enterprise for the purposes of this safe harbor.
The Notice states that a rental real estate enterprise will be treated as a trade or business for the purposes of Section 199A if the following requirements are satisfied during the taxable year:
- Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise;
- 250 hours or more of ‘rental services’ are performed per year for the rental real estate enterprise; and
- The taxpayer maintains contemporaneous records, including time reports or similar documents, regarding:
- hours of all services performed;
- description of services performed;
- dates on which such services are performed;
- and who performed the services.
Rental services can be performed by owners, employees, agents or independent contractors and include: advertising to rent, negotiating and executing leases, daily operation, maintenance and repair, management of the real estate, supervision of employees and independent contractors, collection of rent, and tenant applications. Certain activities related to financial or investment management activities, such as arranging financing, procuring property, reviewing financial statements, or constructing long-term improvements are not considered rental services and the hours spent on these activities will not count for the safe harbor.
The safe harbor does not apply to real estate used by a taxpayer for personal use, and, more importantly, does not apply to real estate leased under triple net lease. This is a commercial leasing term that refers to arrangements in which the tenant is responsible for paying property taxes, building insurance, and common area maintenance costs associated with the leased property. Triple net leases may present an issue for taxpayers that otherwise think they operate a trade or business and are therefore eligible for the Section 199A deduction.
One final requirement for the safe harbor is that the taxpayer or pass-through entity has to attach a statement to the tax return that the requirements in Section 3.03 of the Notice have been satisfied. The statement should be signed by the taxpayer or an authorized representative of the pass-through entity as outlined in Notice 2019-07.
The Section 199A safe harbor provides comfort and certainty for rental businesses, but also creates additional compliance and contemporaneous recordkeeping requirements. For those rental businesses that do not qualify under the safe harbor (such as triple net lease properties), the final regulations state they may still argue their activities rise to the level of Section 162 trade or business based on specific facts and circumstances. They will, however, be faced with a lot of uncertainty given there is no clear guidance and limited history on the treatment of a rental activity as a Section 162 trade or business.
The Notice can be viewed in its entirety by clicking here. Please consult your GBQ tax advisor to determine how best to take advantage of this new guidance.