02.06.2019 The Proposed Real Estate Safe Harbor for the Qualified Business Income Deduction
On January 18th, the U.S. Department of Treasury and the Internal Revenue Service issued a package of guidance relating to the 20-percent qualified business income deduction for non-corporate taxpayers under Section 199A of the Internal Revenue Code. Included among the finalized and proposed regulations in the package was IRS Notice 2019-07, which contains a proposed Revenue Procedure that provides a safe harbor under which a real estate enterprise will be treated as a qualified trade or business for purposes of the 20-percent deduction.
Section 199A of the Internal Revenue Code, as introduced in the law commonly referred to as the Tax Cuts and Jobs Act, is a new deduction for individuals, trusts, and estates of up to twenty percent of total qualified business income plus twenty percent of total qualified REIT dividends and qualified publicly traded partnership income. The new deduction is in effect for taxable years beginning after December 31, 2017 and before December 31, 2025. The deduction’s overall effect could mean a reduction in the top marginal tax rate for individuals, trusts, and estates from 37% to 29.6%.
Important for individuals, trusts, or estates owning or engaged in a real estate enterprise is the clarification under Notice 2019-07 regarding qualified business income. Qualified business income includes items of income, gain, deduction, and loss from a “qualified trade or business” that is effectively connected with a U.S. trade or business. Notice 2019-07 provides a safe harbor for determining when a rental real estate enterprise will be treated as a “qualified trade or business” for purposes of the 20-percent deduction.
A rental real estate enterprise is any interest in real property held for the production of rents and may consist of an interest in multiple properties. Taxpayers must either treat each property held for the production of rents as a separate enterprise or treat all similar properties held for the production of rents as a single enterprise. Commercial and residential real estate may not be part of the same enterprise.
To qualify a rental real estate enterprise as a qualified trade or business under the safe harbor requirements, the taxpayer must:
- Keep separate books and records to reflect income and expenses of each real estate enterprise;
- Perform 250 or more hours of rental services per year (including serviced performed by owners, employees, agents, and/or independent contractors of the owners); and
- Maintain contemporaneous records, including time reports, logs, or similar documents regarding hours of all services performed, a description of all services performed, dates on which the services were performed, and who performed the services with respect to the real estate enterprise.
Rental services include advertising to rent or lease the real estate; negotiating and executing leases; verifying information contained in prospective tenant applications; collecting rent; daily operation, maintenance, and repair of property; and supervising employees and independent contractors. Rental services do not include investment management activities like reviewing financial statements, arranging financing, procuring property, or planning, managing or constructing long-term capital improvements.
Notably, the Treasury and the IRS specifically excluded certain types of arrangements from qualifying under the safe harbor. These include the rental of the taxpayer’s own residence for any part of the year under Section 280A of the Internal Revenue Code and rental properties subject to a triple net lease. A triple net lease is defined under Notice 2019-07 as a lease agreement that requires the tenant or lessee to pay taxes, fees, and insurance, and to be responsible for maintenance activities for a property in addition to rent and utilities. This includes a lease agreement that requires the tenant or lessee 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.
Because this is only a safe harbor, a rental real estate enterprise that does not qualify under the safe harbor may still qualify as a qualified trade or business under a facts and circumstances test.
To apply the safe harbor, taxpayer must attach a statement, invoking perjury penalties, to the tax return claiming the Section 199A deduction.