Rental Real Estate and the Sec. 199A Deduction: Round Two
January 29, 2019
Shortly after Section 199A was added to the Code at the end of 2017, and again after the IRS proposed regulations under the newly-enacted provision last summer, many clients called us with the following question: “Will my rental real estate activities qualify for the 199A deduction?”
In most cases, we were able to answer confidently that the client’s activities would be treated as a qualified trade or business, and that the deduction would be available, though it could be limited by the so-called “W-2 Wages and Unadjusted Basis” limitations.
In a few others, we were able to reply just as certainly that the activities did not rise to the level of a trade or business and, so, would not qualify for the deduction.
In some cases, however, we had to delve more deeply into the client’s particular facts and circumstances before we could reach any conclusion – often with the proviso that the IRS may disagree with our assessment of the situation.
“Trade or Business”
Like many other areas of the tax law, Section 199A requires a taxpayer to make a threshold determination of whether its activities rise to the level of constituting a trade or business.[i]
In general, courts have held that in order for a taxpayer’s activity to rise to the level of constituting a trade or business, the taxpayer must satisfy two requirements: (1) regular and continuous conduct of the activity, which depends on the extent of the taxpayer’s activities;[ii] and (2) a primary purpose to earn a profit, which depends on the taxpayer’s state of mind and their having a good faith intention to make a profit from the activity.[iii]
Whether a taxpayer’s activities meet these factors depends on the facts and circumstances of each case.
In most situations, neither the taxpayer nor the IRS should find it difficult to evaluate the trade or business status of the taxpayer’s activities – the level and quality of the activity will be such that its status will be obvious.
Unfortunately, there remain a number of cases in which the various “triers of fact” – first, the taxpayer, then the IRS, and finally the courts – will have to consider to the taxpayer’s unique “facts and circumstances” in determining whether the taxpayer’s activities rise to the level of a trade or business.
Because it is fact-intensive, while also being subjective, this analytical process can be costly and time-consuming.
It can also generate seemingly inconsistent conclusions by the ultimate trier of fact, a concern that has been borne out historically in the evaluation of smaller rental real estate operations.
One needs to keep the forgoing in mind in order to understand the tentative reaction to the enactment of Section 199A by the owners of many smaller rental real estate operations.
Section 199A provides a deduction to a non-corporate taxpayer[iv] of up to 20 percent of the taxpayer’s qualified business income from each of the taxpayer’s “qualified trades or businesses,” including those operated through a partnership, S corporation, or sole proprietorship, effective for taxable years beginning after December 31, 2017.[v]
Although the passage of Section 199A was greeted enthusiastically by most in the business community, some business owners withheld their endorsement of the provision pending the issuance of guidance as to meaning of certain key terms in the statute.
The rental real estate sector, in particular, hoped that the term “qualified trade or business” would be defined so as to provide its members with some certainty as to the application of the Section 199A deduction to their activities.
However, the statute defined a “qualified trade or business” as any trade or business other than a specified service trade or business or a trade or business of performing services as an employee.
Moreover, the legislative history failed to provide a definition of trade or business for purposes of section 199A.
When the IRS proposed regulations in August of 2018, it stated that Section 162(a)[vi] of the Code provides the most appropriate “definition” of a trade or business for purposes of Section 199A.[vii]
The IRS explained that its decision was based on the fact that the definition of trade or business for purposes of Section 162 is derived from a large body of existing case law and administrative guidance interpreting the meaning of “trade or business” in the context of a broad range of industries.
For this reason, the IRS concluded that the definition of a trade or business under Section 162 provides for administrable rules that are appropriate for the purpose of Section 199A, and which taxpayers have experience applying.
That being said, the proposed regulations extended the definition of trade or business for purposes of Section 199A beyond Section 162 in one circumstance.
Solely for purposes of Section 199A, the IRS proposed that the rental of real property to a related trade or business would be treated as a trade or business if the rental and the other trade or business were commonly controlled. In supporting this extension, the IRS explained that it is not uncommon, for legal or other non-tax reasons, for taxpayers to segregate a rental property from an operating business. According to the IRS, this rule would allow taxpayers to effectively aggregate their trades or business with the associated rental property.[viii]
Notwithstanding the foregoing, the IRS received comments from advisers and industry groups that the status of a rental real estate enterprise as a trade or business within the meaning of Section 199A remained a subject of uncertainty for many taxpayers.
The final regulations retained the proposed regulation’s definition of trade or business; specifically, for purposes of Section 199A and the regulations thereunder, a “trade or business” continues to be defined as a trade or business under Section 162 of the Code.[x]
The IRS acknowledged comments suggesting guidance in the form of a regulatory definition, a bright-line test, or a factor-based test.[xi] The IRS rejected these, however, pointing out that whether an activity rises to the level of a Section 162 trade or business is inherently a factual question, and the factual setting of various trades or businesses varies so widely, that a single rule or list of factors would be difficult to provide in a manageable manner, and would be difficult for taxpayers to apply.[xii]
However, the IRS also recognized the difficulties that a taxpayer may have in determining whether their rental real estate activity is sufficiently regular, continuous, and considerable for the activity to constitute a Section 162 trade or business.
Proposed Safe Harbor
To help mitigate the resulting uncertainty, the IRS recently proposed – concurrently with the release of the final Section 199A regulations – the issuance of a new revenue procedure that would provide for a “safe harbor” under which a taxpayer’s “rental real estate enterprise”[xiii] will be treated as a trade or business for purposes of Section 199A.[xiv]
To qualify for treatment as a trade or business under this safe harbor, a rental real estate enterprise must satisfy the requirements of the proposed revenue procedure. If the safe harbor requirements are met, the real estate enterprise will be treated as a trade or business for purposes of applying Section 199A and its regulations.
Significantly, an S corporation or a partnership[xv] (pass-through entities; “PTE”) that is owned, directly or indirectly, by at least one individual, estate, or trust may also use this safe harbor in order to determine whether a rental real estate enterprise conducted by the PTE is a trade or business within the meaning of Section 199A.[xvi]
Rental Real Estate Enterprise
For purposes of the safe harbor, a “rental real estate enterprise” is defined as an interest in real property held for the production of rents; it may consist of an interest in one or in multiple properties.
The individual or PTE relying on the proposed revenue procedure must hold the interest directly or through an entity that is disregarded as an entity separate from its owner for tax purposes.[xvii]
A taxpayer may treat each property held for the production of rents as a separate enterprise; alternatively, a taxpayer may treat all “similar” properties held for the production of rents as a single enterprise.[xviii] The treatment of a taxpayer’s rental properties as a single enterprise or as separate enterprises may not be varied from year-to-year unless there has been a “significant”[xix] change in facts and circumstances.
Commercial and residential real estate may not be part of the same rental enterprise; in other words, a taxpayer with an interest in a commercial rental property, who also owns an interest in a residential rental, will be treated as having two rental real estate enterprises for purposes of applying the revenue procedure.
Rental as Section 199A Trade or Business
A rental real estate enterprise will be treated as a trade or business for a taxable year (solely for purposes of Section 199A) if the following requirements are satisfied during the taxable year with respect to the rental real estate enterprise:
(A) Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise, as well as a separate bank account for each enterprise;[xx]
(B) For taxable years beginning:
(i) prior to January 1, 2023, 250 or more hours of “rental services”[xxi] are performed per year with respect to the rental enterprise;
(ii) after December 31, 2022, in any three of the five consecutive taxable years that end with the taxable year (or in each year for an enterprise held for less than five years), 250 or more hours of rental services are performed per year with respect to the rental real estate enterprise; and
(C) The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, regarding the following:
(i) hours of all services performed;
(ii) description of all services performed;
(iii) dates on which such services were performed; and
(iv) who performed the services.
Such records are, of course, to be made available for inspection at the request of the IRS.[xxii]
The rental services to be performed with respect to a rental real estate enterprise for purposes of satisfying the safe harbor include the following:
(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 and payment of expenses;
(v) daily operation, maintenance, and repair of the property;
(vi) management of the real estate;
(vii) provision of services to tenants;[xxiii]
(viii) purchase of materials; and
(ix) supervision of employees and independent contractors.[xxiv]
Rental services may be performed by the individual owners (in the case of direct ownership of the real property) or by the PTE that owns the property, or by the employees, agents, and/or independent contractors of the owners.
It is important to note that hours spent by an owner or any other person with respect to the owner’s capacity as an investor are not considered to be hours of service with respect to the enterprise. Thus, the proposed revenue procedure provides that the term “rental services” does not include the following:
(i) financial or investment management activities, such as arranging financing;
(ii) procuring property;
(iii) studying and reviewing financial statements or reports on operations;
(iv) planning, managing, or constructing long-term capital improvements; or
(v) traveling to and from the real estate.[xxv]
Real estate used by the taxpayer (including by an owner of a PTE relying on this safe harbor) as a residence for any part of the year[xxvi] is not eligible for the safe harbor.
Real estate rented under a triple net lease is also not eligible for the safe harbor – it more closely resembles an investment than a trade or business. For purposes of this rule, a “triple net lease” includes a lease agreement that requires the tenant to pay taxes, fees, and insurance, and to be responsible for maintenance activities for a property in addition to rent and utilities. This also includes a lease agreement that requires the tenant to pay a portion of the taxes, fees, and insurance, and to be responsible for maintenance activities allocable to the portion of the property rented by the tenant.
Procedural Requirements, Reliance
A taxpayer or PTE must include a statement attached to the return on which it claims the Section 199A deduction or passes through Section 199A information that the requirements in the revenue procedure have been satisfied. The statement must be signed by the taxpayer, or an authorized representative of an eligible taxpayer or PTE, which states:
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 execute the statement must have personal knowledge of the facts and circumstances related to the statement.
If an enterprise fails to satisfy these requirements, the rental real estate enterprise may still be treated as a trade or business for purposes of Section 199A if the enterprise otherwise meets the general definition of trade or business.[xxvii]
The proposed revenue procedure is proposed to apply generally to taxpayers with taxable years beginning after December 31, 2017; i.e., the effective date for Section 199A.
In addition, until such time that the proposed revenue procedure is published in final form, taxpayers may use the safe harbor described in the proposed revenue procedure for purposes of determining when a rental real estate enterprise may be treated as a trade or business solely for purposes of Section 199A.
All in all, the final regulations and the proposed safe harbor should provide some welcomed relief and “certainty” for those individual taxpayers and PTEs that own smaller rental real estate operations;[xxviii] and they came just in time – barely – for the preparation of these taxpayers’ 2018 tax returns.
But the proof is in the pudding – or something like that – and the actual impact of the proposed safe harbor will have to await the collection and analysis of the relevant data, including the reactions of taxpayers and their advisers.
As in the case of many other taxpayer-friendly regulations or procedures,[xxix] the benefit afforded requires that the taxpayer be diligent in maintaining contemporaneous, detailed records for each rental real estate enterprise. This may be a challenge for many a would-be qualified trade or business.
Whether to treat “similar” rental properties as a single enterprise may also present some difficulties for taxpayers, at least until they figure out what it means for one property to be similar to another. Based upon the term’s placement in the proposed revenue procedure, it may be that all residential properties are similar to one another, just as all commercial properties are similar to one another. In that case, a taxpayer may be able to treat all of its residential rentals, for example, as a single enterprise, which may allow it to satisfy the “250 or more hours of rental service” requirements of the safe harbor.
Just as challenging may be a taxpayer’s distinguishing between business-related services and investment-related services.[xxx]
Regardless of how the proposed safe harbor is ultimately implemented and administered, the fact remains that the IRS has clearly considered and responded to the requests of the rental real estate industry.
The questions remain, however: Will Section 199A survive through its scheduled expiration date in 2025; and, if so, will it become a “permanent” part of the Code? Or is all this fuss just a way to drive folks like me crazy?
For example, expenses are deductible if they are incurred “in carrying on any trade or business.” IRC Sec.162.
[ii] Which may distinguish a trade or business from an “investment.”
[iii] As opposed to a “hobby.”
[iv] Individuals; also trusts and estates.
[v] Tax Cuts and Jobs Act, PL 115-97, Sec. 11011. The deduction disappears for taxable years beginning after December 31, 2025.
[vi] https://www.law.cornell.edu/uscode/text/26/162. In general, Section 162 of the Code provides that the ordinary and necessary expenditures directly connected with or pertaining to a taxpayer’s “trade or business” are deductible in determining the taxpayer’s taxable income.
[viii] The final regulations clarify the rule by limiting its application to situations in which the related party tenant is an individual or an PTE (not a C corporation).
[x] Other than the trade or business of performing services as an employee.
[xi] It also considered and rejected suggestions that it define trade or business by reference to Section 469 of the Code, explaining that the definition of trade or business for Section 469 purposes is significantly broader than the definition for purposes of Section 162 as it is intended to capture a “larger universe” of activities, including passive activities. According to the IRS, Section 469 was enacted to limit the deduction of certain passive losses and therefore, serves a very different purpose than the allowance of a deduction under section 199A. Further, Section 199A does not require that a taxpayer materially participate in a trade or business in order to qualify for the Section 199A deduction.
The IRS also declined to adopt a suggestion that all rental real estate activity be deemed to be a trade or business for purposes of Section 199A.
[xii] In determining whether a rental real estate activity is a section 162 trade or business, relevant factors might include, but are not limited to (i) the type of rented property (commercial real property versus residential property), (ii) the number of properties rented, (iii) the owner’s or the owner’s agents day-to-day involvement, (iv) the types and significance of any ancillary services provided under the lease, and (v) the terms of the lease (for example, a net lease versus a traditional lease and a short-term lease versus a long-term lease).
[xiii] Yes, another defined term.
[xiv] Notice 2019-07. https://www.irs.gov/pub/irs-drop/n-19-07.pdf
[xv] Other than a publicly traded partnership.
[xvi] You may recall that it is up to the PTE (not its owners) to determine whether it is engaged in a qualified trade or business.
[xvii] Reg. Sec. 301.7701-3; for example, a single-member LLC; so, two tiers of entities at most (one of which must be disregarded) – an S corp. that owns an interest in a 2-person partnership that owns rental real estate would not qualify.
[xviii] There is no in-between, where some similar properties are treated as one enterprise while others as separate enterprises.
[xix] As of yet undefined.
[xx] Query how this may affect a taxpayer’s decision to treat all “similar” properties held for the production of rents as a single enterprise?
[xxi] You guessed it. C’mon, it’s tax – we love defined terms within defined terms. They put Russian nesting dolls to shame.
[xxii] The contemporaneous records requirement will not apply to taxable years beginning prior to January 1, 2019.
[xxiii] Although not spelled out in the proposed revenue procedure, presumably this includes some of the following: providing and paying for gas, water, electricity, sewage, and insurance for the property; paying the taxes assessed thereon; providing insect control, janitorial service, trash collection, ground maintenance, and heating, air conditioning and plumbing maintenance.
[xxiv] This does not purport to be an all-inclusive list.
[xxv] The number of times I have seen taxpayers count such travel time in trying to establish their material participation for purposes of the passive activity rules!
[xxvi] Under section 280A of the Code. In general, a taxpayer uses a property during the taxable year as a residence if he uses such property for personal purposes for a number of days which exceeds the greater of: 14 days, or 10 percent of the number of days during such year for which such property is rented at a fair rental.
[xxvii] Under Section 162, which may be small comfort – after all, that’s why the safe harbor was proposed.
[xxviii] Not that everything was rosy. Example 1 of proposed §1.199A-1(d)(4) described a taxpayer who owns several parcels of land that the taxpayer manages and leases to airports for parking lots. The IRS shared that some taxpayers questioned whether the use of the lease of unimproved land in the example was intended to imply that the lease of unimproved land is a trade or business for purposes of section 199A. The IRS explained that the example was intended to provide a simple illustration of how the 199A calculation would work; it was not intended to imply that the lease of the land is, or is not, a trade or business for purposes of section 199A beyond the assumption in the example. In order to avoid any confusion, the final regulations removed the references to land in the example.
[xxix] For example, the material participation regulations under Reg. Sec. 1.469-5T.
[xxx] For example, attending a hearing of a local zoning board.