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IRS Expands and Finalizes Section 199A Safe Harbor for Rental Real Estate
(Parker Tax Publishing September 2019)
The IRS finalized a safe harbor revenue procedure under which a rental real estate enterprise will be treated as a trade or business for purposes of Code Sec. 199A. The procedure includes several changes from a proposed revenue procedure previously issued in Notice 2019-7, such as (1) allowing taxpayers to treat their interests in residential or commercial properties as separate rental real estate enterprises in one year and then treating their interests in all similar residential or all similar commercial properties as a single rental real estate enterprise in a future year; (2) allowing taxpayers with rental real estate enterprises that have been in existence for four or more years to qualify immediately under the 250-hour rental services test if the rental services have been provided in three of the five consecutive tax years ending with the tax year at issue; and (3) allowing an interest in mixed-use property to be treated as a single rental real estate enterprise or bifurcated into separate residential and commercial interests. Rev. Proc. 2019-38.
Practice Aid: Sample Safe Harbor Election Statement: Rental Real Estate Enterprises. and Sample Client Letter: Rental Real Estate Safe Harbor.
Background
Reg. Sec. 1.199A-1(b)(14) defines the term "trade or business" for purposes of the deduction under Code Sec. 199A as a trade or business under Code Sec. 162 other than the trade or business of performing services as an employee. In addition, Reg. Sec. 1.199A-1(b)(14) provides that the renting or licensing of tangible or intangible property (rental activity) that does not rise to the level of a Code Sec. 162 trade or business is nevertheless treated as a trade or business for purposes of Code Sec. 199A if the property is rented or licensed to a trade or business conducted by the individual or a relevant passthrough entity (RPE) which is commonly controlled under Reg. Sec. 1.199A-4.
Earlier this year, in order to address questions of whether a rental real estate enterprise rises to the level of a trade or business for purposes of the Code Sec. 199A deduction, the IRS issued Notice 2019-7. In Notice 2019-7, the IRS set forth a proposed revenue procedure containing a safe harbor for treating a rental real estate enterprise as a trade or business solely for purposes of Code Sec. 199A. On September 24, after considering the public's comments on Notice 2019-7, the IRS issued Rev. Proc. 2019-38.
Rev. Proc. 2019-38
If the requirements in Rev. Proc. 2019-38 are met, a taxpayer's rental real estate enterprise will be treated as a single trade or business as defined in Code Sec. 199A(d) for purposes of applying the regulations under Code Sec. 199A, including the application of the aggregation rules in Reg. Sec. 1.199A-4. RPEs may also use this safe harbor. In order to rely upon the safe harbor, taxpayers and RPEs must satisfy all of the requirements in Rev. Proc. 2019-38.
Observation: However, as also stated in Notice 2019-7, failure to satisfy the safe harbor requirements does not preclude a taxpayer or the IRS from otherwise establishing that an interest in rental real estate is a trade or business for purposes of Code Sec. 199A.
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 and may consist of an interest in a single property or interests in multiple properties. The taxpayer or RPE relying on Rev. Proc. 2019-38 must hold each interest directly or through an entity disregarded as an entity separate from its owner under any provision of the Code.
Generally, taxpayers and RPEs may either treat each interest in similar property held for the production of rents as a separate rental real estate enterprise or treat interests in all similar properties held for the production of rents as a single rental real estate enterprise. For purposes of applying Rev. Proc. 2019-38, properties held for the production of rents are similar if they are part of the same rental real estate category. 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 real estate held for the production of rents may only be part of the same enterprise with other commercial real estate, and residential properties may only be part of the same enterprise with other residential properties.
Once a taxpayer or RPE treats interests in similar commercial properties or similar residential properties as a single rental real estate enterprise under the safe harbor, the taxpayer or RPE must continue to treat interests in all similar properties, including newly acquired properties, as a single rental real estate enterprise when the taxpayer or RPE continues to rely on the safe harbor. However, a taxpayer or RPE that chooses to treat its interest in each residential or commercial property as a separate rental real estate enterprise may choose to treat its interests in all similar commercial or all similar residential properties as a single rental real estate enterprise in a future year.
An interest in mixed-use property may be treated as a single rental real estate enterprise or may be bifurcated into separate residential and commercial interests. For purposes of Rev. Proc. 2019-38, mixed-use property is defined as a single building that combines residential and commercial units. An interest in mixed-use property, if treated as a single rental real estate enterprise, may not be treated as part of the same enterprise as other residential, commercial, or mixed-use property.
Each rental real estate enterprise that satisfies the requirements of this safe harbor is treated as a separate trade or business for purposes of applying Code Sec. 199A and the regulations thereunder.
Safe Harbor Requirements
The determination to use the safe harbor in Rev. Proc. 2019-38 must be made annually. Solely for the purposes of Code Sec. 199A, each rental real estate enterprise will be treated as a single trade or business if the following requirements are satisfied during the tax year with respect to the rental real estate enterprise:
(1) Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise. If a rental real estate enterprise contains more than one property, this requirement may be satisfied if income and expense information statements for each property are maintained and then consolidated;
(2) For rental real estate enterprises that have been in existence less than four years, 250 or more hours of rental services are performed per year with respect to the rental real estate enterprise. For rental real estate enterprises that have been in existence for at least four years, in any three of the five consecutive tax years that end with the tax year, 250 or more hours of rental services are performed per year with respect to the rental real estate enterprise; and
(3) 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. If services with respect to the rental real estate enterprise are performed by employees or independent contractors, the taxpayer may provide a description of the rental services performed by such employee or independent contractor, the amount of time such employee or independent contractor generally spends performing such services for the enterprise, and time, wage, or payment records for such employee or independent contractor. Such records are to be made available for inspection at the request of the IRS.
Compliance Tip: The taxpayer or RPE attaches a statement to a timely filed original return (or an amended return for the 2018 tax year only) for each tax year in which the taxpayer or RPE relies on the safe harbor. An individual or RPE with more than one rental real estate enterprise relying on this safe harbor may submit a single statement but the statement must list the required information separately for each rental real estate enterprise. The statement must include the following information: (1) a description (including the address and rental category) of all rental real estate properties that are included in each rental real estate enterprise; (2) a description (including the address and rental category) of rental real estate properties acquired and disposed of during the tax year; and (3) a representation that the requirements of Rev. Proc. 2019-38 have been satisfied.
For purposes of Rev. Proc. 2019-38, rental services include, but are not limited to:
(1) advertising to rent or lease the real estate;
(2) negotiating and executing leases;
(3) verifying information contained in prospective tenant applications;
(4) collecting rent;
(5) daily operation, maintenance, and repair of the property, including the purchase of materials and supplies;
(6) management of the real estate; and
(7) supervision of employees and independent contractors.
Rental services may be performed by owners, including owners of an RPE, 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; procuring property; studying and reviewing financial statements or reports on operations; improving property under Reg. Sec. 1.263(a)-3(d); or hours spent traveling to and from the real estate.
Certain rental real estate arrangements are excluded from the safe harbor provisions of Rev. Proc. 2019-38. The following types of property may not be included in a rental real estate enterprise and are therefore not eligible for the safe harbor:
(1) real estate used by the taxpayer (including an owner or beneficiary of an RPE) as a residence under Code Sec. 280A(d).
(2) real estate rented or leased under a triple net lease. For purposes of Rev. Proc. 2019-38, a triple net lease includes a lease agreement that requires the tenant or lessee to pay taxes, fees, and insurance, and to pay for maintenance activities for a property in addition to rent and utilities.
(3) real estate rented to a trade or business conducted by a taxpayer or an RPE which is commonly controlled under Reg. Sec. 1.199A-4(b)(1)(i).
(4) the entire rental real estate interest if any portion of the interest is treated as a specified service trade or business (SSTB) under Reg. Sec. 1.199A-5(c)(2) (which provides special rules where property or services are provided to an SSTB).
Effective Date
Rev. Proc. 2019-38 applies to tax years ending after December 31, 2017. Alternatively, taxpayers and RPEs may rely on the safe harbor set forth in Notice 2019-7 for the 2018 tax year. The contemporaneous records requirement will not apply to tax years beginning before January 1, 2020. However, taxpayers bear the burden of showing the right to any claimed deductions in all tax years.
For a discussion of whether rental real estate activities are a trade or business for purposes of Code Sec. 199A, see Parker Tax ¶152,120.
Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.
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