The Internal Revenue Service (IRS) recently concluded its deliberations on the Section 199A real estate safe harbor with the issuance of Revenue Procedure 2019-38 in September. While much of the proposed safe harbor remains intact, several pivotal distinctions have emerged in the final version. This article undertakes a comprehensive analysis of the finalized safe harbor rules, shedding light on the critical changes and their implications.
Understanding Section 199A: A Brief Overview
Enacted as part of the Tax Cuts and Jobs Act of 2017, Section 199A offers a 20% deduction of qualified business income for non-C corporate taxpayers. This deduction is applicable to businesses operating through partnerships, S corporations, sole proprietorships, as well as real estate investments and qualified publicly traded income. However, to qualify for the deduction, the business activity must ascend to the level of a trade or business, excluding specified service trades or businesses.
Addressing the Gray Areas: Real Estate Rental Activities
A key challenge arises in determining whether a real estate rental activity meets the threshold of a trade or business, given the ambiguity in Section 199A(d). Court cases have yielded varying outcomes, with some recognizing a single rental as a trade or business while others do not. To alleviate this uncertainty, the IRS introduced a safe harbor, providing clarity on eligibility for the 20% deduction, even if the rental activity, in isolation, falls short of constituting a trade or business.
Real Estate Enterprises and Grouping
The finalized safe harbor introduces the concept of "Real Estate Enterprises" to delineate rentals eligible for the deduction. An enterprise may comprise one or more properties, with the stipulation that only rentals falling within the same category can be grouped together. Commercial and residential rentals must remain separate, while mixed-use properties can be treated as a single activity or bifurcated into residential and commercial components. Importantly, once properties are grouped under this safe harbor, they must maintain that grouping in subsequent years, encompassing newly acquired assets.
Four Requirements for Separate Trade or Business Treatment
The IRS outlines four requirements for treating each real estate enterprise as a separate trade or business:
- Separate Books Maintenance: Each enterprise must maintain distinct books.
- Hourly Service Threshold: For enterprises existing less than four years, a minimum of 250 service hours must be performed annually. For enterprises in operation for at least four years, the 250-hour requirement can be met in any three of the prior five years.
- Contemporaneous Record-Keeping: Taxpayers must maintain contemporaneous records detailing hours of service, service descriptions, work dates, and the personnel involved. Notably, this record-keeping requirement applies to tax years commencing after January 1, 2020, offering relief from the initially proposed rules.
- Filing a Statement: Taxpayers or relevant pass-through entities (RPEs) must attach a statement to the tax return each year the safe harbor is relied upon. The statement should include property descriptions, addresses, rental categories, and details of properties acquired and disposed of during the year.
Rental Services and the 250-Hour Requirement
Rental services encompassing various activities contribute towards the 250-hour requirement, including advertising, lease negotiations, applicant verification, rent collection, daily operations, maintenance, repair, property management, and employee or contractor supervision. However, time spent on travel to/from rentals and financial or investment management activities such as arranging financing or studying financial information is excluded from rental services.
Real Estate Not Covered by the Safe Harbor
While the safe harbor provides clarity, it's imperative to note the exclusions. The following scenarios are not eligible for the safe harbor:
- Property Under 280A(d): Properties used under specific provisions.
- Triple Net Lease Properties: Those subject to a triple net lease.
- Commonly Controlled Business Rentals: Real estate rented to a trade or business commonly controlled by the taxpayer or RPE.
- SSTB Component: If any portion of the rental is treated as a specified service trade or business (SSTB) due to common ownership with a service business owner.
Navigating the Safe Harbor Landscape
The finalized Section 199A real estate safe harbor rules provide a structured framework for taxpayers seeking clarity on the eligibility of their rental activities for the 20% deduction. The delineation of Real Estate Enterprises, grouping rules, and specific requirements for separate trade or business treatment contribute to a more definitive landscape. As taxpayers adapt to these finalized rules, a proactive approach to record-keeping, contemporaneous documentation, and adherence to the specified guidelines will be crucial for harnessing the benefits of the safe harbor.