Julie K. Kelly
Sussman Shank LLP
On September 24, 2019, the IRS clarified the uncertainty surrounding the qualification of a rental real estate enterprise as a trade or business for purposes of section 199A of the Tax Cuts and Jobs Act (“section 199A”). Revenue Procedure 2019-38 (“Rev. Proc. 2019-38”) establishes a safe harbor under which a taxpayer operating a domestic rental real estate business may take advantage of the section 199A deduction of qualified business income (“QBI”). Specifically, a business operated by an individual taxpayer or a relevant pass-through entity (“RPE”) may deduct up to 20 percent of its QBI; RPEs include sole proprietorships, partnerships, and S corporations.
Rev. Proc. 2019-38 defines a rental real estate enterprise (“RE enterprise”) as “an interest in real property held for the production of rents.” The interest must be held by the taxpayer or the RPE (collectively referred to herein as “taxpayer”) directly or via an entity disregarded for tax purposes. In addition, the taxpayer must meet the following requirements:
Real Estate Categories. For purposes of the safe harbor, there are two real estate categories — commercial and residential. The taxpayer may characterize each property interest as a separate RE enterprise or, in the alternative, treat all interests in commercial property as a single RE enterprise and all interests in residential property as a single RE enterprise. To the extent a particular property is used for both commercial and residential purposes, such property may be characterized as a single RE enterprise or split into separate interests for reporting purposes. Once a single RE enterprise is established for multiple properties within the same category, the taxpayer must continue to characterize all such properties as a single RE enterprise in future years, including properties acquired after the year in which the single RE enterprise is established.
Rental Services. 250 hours of rental services must be performed annually for RE enterprises that have been operating for less than four years. RE enterprises that have been operating for more than four years only need to provide evidence that the annual 250-hour requirement was satisfied for at least three of the last five consecutive tax years. Rental services may be performed by owners, employees, agents, or independent contractors. Qualifying rental services include advertising, negotiating lease agreements, due diligence of tenant applications, rent collection, maintenance and repairs, and supervision of employees and independent contractors. Investment and financial analysis activities do not qualify as “rental services” for purposes of the safe harbor, nor do hours traveling to and from the rental properties.
Statement of Reliance on Safe Harbor. Finally, the taxpayer must attach a statement to the applicable return detailing its reliance on the safe harbor. This is an annual requirement, so the statement must be attached to each return under which the taxpayer elects to rely on the safe harbor. In addition to a representation that the requirements of Rev. Proc. 2019-38 have been met, the attachment must contain (1) a description of each real property included in each of the taxpayer’s RE enterprises and (2) a summary of the newly acquired properties and properties disposed of during the tax year for which the return is being filed.
Disqualifying Factors. Not surprisingly, any real property used by the taxpayer (or an owner or a beneficiary of the RPE) as a personal residence will not qualify for the safe harbor, nor will leased property governed by a triple net lease. Also excluded is real estate leased to a trade or business of the taxpayer (including a commonly controlled RPE) and real estate in which any portion of the interest is treated as a specified service trade or business (“SSTB”). An interest will be characterized as a SSTB if the property (1) is leased to a business performing services in the industries of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, and trading; and (2) 50 percent or more of such service business is commonly owned with the RE enterprise.[1]
Rev. Proc. 2019-38 applies to tax year 2018, so an amended return may be filed. The Tax Cuts and Jobs Act is scheduled to sunset in 2026. Thus, absent additional congressional action, the final year taxpayers can rely on the safe harbor is 2025. It is important to note that even if a taxpayer fails to satisfy the safe harbor requirements, it may nevertheless rely on the definition of “trade or business” under Treasury Regulation section 1.199A-1(b)(14)[2] to claim the deduction.
[1] § 1.199A-5(c)(2)
[2] Treasury Regulation section 1.199A-1(b)(14) defines trade or business as a trade or business under section 162 other than the trade or business of performing services as an employee. IRC section 162(a), however, fails to define trade or business. Rather, it allows a deduction of “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” Presumably, the regulations for 199A direct us to section 162(c) case law for determining whether an activity qualifies as a trade or business. “[W]hether the activities of a taxpayer are ‘carrying on a business’ requires an examination of the facts in each case.” Higgins v. Commissioner, 312 U.S. 212, 217 (1941); see also Commissioner v. Groetzinger, 480 U.S. 23 (1987) (establishing two definitional requirements: first, there must be an intent to make a profit; and second, the business must necessitate regular, continuous activity.)