Understanding the Safe Harbor Rule for Rental Real Estate EnterprisesNovember 22, 2019
By Anthony Delvalle, CPA
Senior Manager, Real Estate Group
In 2017, the Tax Cuts and Jobs Act (TCJA) introduced a new 20% tax deduction (the 199A deduction) for qualifying business income from partnerships, S corporations and sole proprietors. Proposed regulations issued in the summer of 2018 created some concern as to which rental real estate activities would qualify as a “trade or business” under these provisions, allowing the rental income to be eligible for this tax break.
Much of this concern arose from the fact that while the Internal Revenue Code (IRC) uses the phrase “trade or business,” it is not defined there. Courts have long adopted a “facts and circumstances” approach in determining whether a particular endeavor indeed constituted a trade or business. Generally, courts have supported trade or business treatment when the activity is conducted for profit and is engaged in (even if not by the taxpayer itself) with regularity and continuity. In interpreting these requirements in the rental real estate area, case law has supported trade or business treatment when additional services are provided to tenants. On September 24, 2019, the Internal Revenue Service (IRS) issued Revenue Procedure 2019-38, finalizing a “safe harbor” rule initially proposed in January to allow an investor’s real estate rental enterprise to be considered a trade or business and qualify for the 199A deduction.
A rental real estate enterprise is defined, for purposes of the safe harbor, as an interest in real property held for the production of rents owned by an individual or relevant passthrough entity (RPE) which may consist of an interest in multiple properties. An RPE is defined as a partnership or an S corporation that is owned, directly or indirectly, by at least one individual, estate or trust. In order to qualify for the safe harbor test, the rental real estate interest must be owned directly by the individual, RPE or through a disregarded entity (i.e., a business entity with one owner that is not recognized for tax purposes as an entity separate from its owner).
Taxpayers either must treat each rental activity as a separate enterprise or treat all similar properties as a single enterprise. The two types of rental real estate categories for the purpose of combining properties into a single rental real estate enterprise are residential and commercial. Thus, commercial and residential rental real estate cannot be combined in the same enterprise.
WHAT ARE THE ELIGIBILITY REQUIREMENTS?
To be eligible for the 199A deduction under the safe harbor, the rental real estate enterprise will be treated as a trade or business if the following criteria are met:
• Maintain separate books and records for each rental real estate enterprise.
• 250 or more hours of rental services are performed during the year with respect to the rental enterprise. Rental services include advertising for rent or lease, negotiating and executing leases, verifying tenant applications, rent collection, daily operation, maintenance and repair of property; managing the real estate; purchase of materials; and supervision of employees and independent contractors. It’s also important to note that for rental real estate enterprises that have been in existence for at least four years, the 250 or more hours requirement can be satisfied in three of the previous five years.
• Beginning in 2020, real estate enterprises must maintain contemporaneous records, including time reports, logs or similar documents, to support the hours, dates, description and provider of the services performed. If services with respect to the rental real estate enterprise are performed by employees or independent contractors, the taxpayer may take into account the amount of time the employee or contractor spends on rental services, rather than provide detailed time, wage and payment records, as long as the taxpayer has these records available for inspection at the request of the IRS.
• Each year, the taxpayer or RPE must attach a statement to the tax return filed for the tax year(s) the safe harbor is relied upon. The statement must include a description of all properties included in the rental real estate enterprise, properties acquired and disposed of during the taxable year and a representation that the requirements of this revenue procedure have been satisfied.
EXCLUSIONS FROM THE SAFE HARBOR TEST
The following types of property are not eligible for the safe harbor test:
1. Real estate used by the taxpayer as a residence for more than 14 days during the year.
2. Real estate rented or leased on a triple net basis. A triple net lease is any lease where the landlord passes on the responsibility for paying real estate taxes, insurance and other maintenance costs to the tenant. The IRS views the ownership of real estate rented on a triple net basis as an investment rather than a Section 162 trade or business.
3. Real estate rented to a trade or business with common ownership.
4. Real estate, if any portion is treated as a specified service trade or business, under special rules where property is provided to a specified service trade or business.
Taxpayers who do not meet the safe harbor requirements still have the opportunity to prove that their rental real estate qualifies as a trade or business for purposes of the 199A deduction. This will be determined based on the traditional facts and circumstances analysis of the taxpayer’s rental activities. Records should still be kept for all rental services performed for the rental real estate enterprise, as the taxpayer will be required to back up this claim if challenged by the IRS.