The Internal Revenue Service (IRS) has finalized guidance regarding rental real estate and whether that activity qualifies for treatment as a trade or business for purposes of the QBI deduction introduced with the Tax Cuts and Jobs Act of 2017. In this article, we explain the safe harbor recently provided in Revenue Procedure 2019-38.
The 2017 Tax Cuts and Jobs Act (TCJA) contained numerous tax changes, including reducing the federal income tax rate applicable to C corporations from 35% to a flat 21%. However, the highest marginal federal income tax rate, now 37%, still applied to individual owners of pass-through entities (such as S corporations). To counteract this rate discrepancy, the TCJA included I.R.C. Section 199A, which allows eligible individuals, estates, and certain trusts that operate as sole proprietorships, partnerships, and S corporations to deduct up to 20% of “qualified business income” (QBI) on the owner’s federal income tax return. The QBI deduction is effective for tax years beginning after 2017 and before 2026.
Note: QBI specifically excludes W-2 income, salaries by an S corporation to its shareholder-employees, and guaranteed payments to partners. Therefore, if the only amount received by a shareholder-employee of an S corporation was classified as W-2 income, that would not qualify as QBI or the related deduction.
Traditionally, whether rental real estate is a trade or business requires a taxpayer to demonstrate that the primary purpose is to earn a profit and the activities must be conducted in a regular and continuous manner. The specific application of the QBI deduction is subject to a complex set of regulations and limitations, including what constitutes a “qualified trade or business[.]”1 Treasury Regulation Section 1.199A-1(b)(14) includes guidance concerning the definition of a trade or business for purposes of I.R.C. Section 199A. Fortunately, the IRS just issued Revenue Procedure 2019-38, which provides a safe harbor and procedural requirements under which a rental real estate enterprise will be treated as a qualified trade or business solely for purposes of I.R.C. Section 199A.
Rental real estate is commonly referred to as investment property or a group of investment properties. However, Revenue Procedure 2019-38 uses the term “rental real estate enterprise” (RREE) to refer to an interest in real property held for the production of rents. Rental or investment property(ies) is treated as a qualified trade or business if the interest in real property is held for the production of rents. A taxpayer must treat each property held for the production of rents either as a separate RREE, or treat all similar properties held for the production of rents as a single RREE. The revenue procedure provides that properties are similar if within “the same rental real estate category.” Thus, commercial and residential real estate cannot be co-mingled in the same RREE.
Requirements of the Safe Harbor
Each RREE will be treated as a qualified trade or business if all the following requirements are satisfied.
1. Separate Books and Records: Separate books and records are maintained to reflect income and expenses.
2. Hours Requirement: For RREEs that have been in existence less than four years, at least 250 hours of “rental services” must be performed each year with respect to the RREE. For RREEs that have been in existence for at least four years, “in any three of the five consecutive taxable years that end with the taxable year,” at least 250 hours of rental services must be performed with respect to the RREE.
(a) Revenue Procedure 2019-38 describes rental services to include “(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; (v) daily operation, maintenance, and repair of the property, including the purchase of materials and supplies; (vi) management of the real estate; (vii) supervision of employees and independent contractors. Rental services may be performed by owners, including owners of relevant pass-through entity (RPE), or by employees, agents, and/or independent contractors of the owners.”
(b) Certain financial and investment management activities (e.g., reviewing financial statements, arranging for financing, procuring property, or traveling to properties) are specifically excluded from rental services. Therefore, the time reviewing financial statements or planning rental real estate acquisitions cannot be included for purposes of satisfying the hours requirement.
3. Contemporaneous Records: The taxpayer must maintain 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.” This requirement will not apply to taxable years beginning prior to January 1, 2020.”
4. Notice of Reliance on Safe Harbor. The taxpayer or RPE must attach “a statement to a timely filed original return (or an amended return for the 2018 taxable year only) for each taxable year in which the taxpayer or RPE relies on the safe harbor.”
The revenue procedure applies to taxable years ending after December 31, 2017. However, for the 2018 taxable year, taxpayers may rely on the safe harbor identified in IRS Notice 2019-07 released earlier this year or the just released Revenue Procedure 2019-38.
Excluded from Safe Harbor Treatment
Real estate used as a residence by the taxpayer (including an owner or beneficiary of an RPE) for any part of a tax year under I.R.C. Section 280A(d) is not eligible for this safe harbor. In addition, real estate leased under a triple net lease (where the tenant pays all expenses of the property including real estate taxes, building insurance, and maintenance) is excluded. Finally, real estate rented to a trade or business conducted by the taxpayer or RPE which is commonly controlled under Treasury Regulation Section 1.199A-4(b)(1)(i) is excluded.
Even if the above safe harbor test is not satisfied, the RREE can still be treated as a qualified trade or business if it meets the definition in Treasury Regulation Section 1.199A-1(b)(14) (e.g., an I.R.C. Section 162 trade or business). Given the complexity of I.R.C. Section 199A and its implementing regulations, we recommend that taxpayers consult with a tax advisor to determine how the QBI rules apply to their specific circumstances.
At Henson Efron, our attorneys help clients with a wide variety of tax issues. If you’d like to learn more about how our experience and knowledge can help you and your business, please contact us.
The purpose of this article is meant to provide general information and should not be construed as legal or tax advice.
1I.R.C. Section 199A(d)(1).