The new tax law effective for the 2018 tax year provides a new income tax deduction for business income earned from pass-through entities under Code §199A. On January 18, 2019, the Treasury Department and the Internal Revenue Service issued final regulations and additional guidance to calculate the new deduction. There are numerous requirements to meet, and one of these is that the business must constitute a trade or business to receive the new deduction.
Unfortunately, for rental real estate activities, it is not often clear whether the rental activity constitutes a trade or business in the eye of the IRS. To assist taxpayers, the IRS has published Notice 2019-07 which provides a safe harbor to obtain trade or business status for rental real estate activities. In order to apply the safe harbor, a taxpayer attaches a statement to the tax return reporting the section 199A deduction. Note that if a taxpayer does not meet the requirements, they can still claim trade or business status – they just do not have the benefit of automatic IRS approval of that conclusion via the safe harbor.
Safe harbor for rental real estate requirements
Under the safe harbor, a “rental real estate enterprise” (defined below) will be treated as a trade or business if it meets the following requirements:
- Separate books and records and separate bank account are maintained to reflect income and expenses for each rental real estate enterprise
- 250 or more hours of rental services (defined below) are performed per year for tax years beginning before Jan. 1, 2023 effective for the 2018 tax year
- The taxpayer must 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. (Records requirement not effective until 2020 tax year)
New rental real estate enterprise (RPE) definition
A rental real estate enterprise is defined as an interest in real property held to produce rents and may consist of an interest in multiple properties. Taxpayers can treat each rental real estate property as a stand-alone enterprise or group together similar properties and treat each group as an enterprise. Relevant passthrough entities (partnerships, S corporations, trusts and estates) can use this test as well as individuals. Commercial and residential real estate may not be a part of the same rental real estate enterprise.
Rental services defined for 250-hour test
Rental services may be performed by owners, employees, agents, management companies or independent contractors. 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 the property; managing the real estate; purchasing materials; and supervising employees and independent contractors.
Qualifying rental services do not include:
- Financial or investment management activities such as arranging financing, procuring property, reviewing financial statements or operations reports, planning, managing or constructing long-term capital improvements or travel to and from the real estate properties.
Real estate used by the taxpayer (including an owner or beneficiary of an RPE relying on this safe harbor) as a residence for any part of the year is not eligible for this safe harbor. Real estate rented or leased under a triple net lease is also not eligible for this safe harbor. For purposes of this revenue procedure, a triple net lease includes 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 article was originally issued in February of 2019. We have updated the article with the changes made to the final regulations on September 24, 2019. The changes are highlighted below:
- Taxpayer doesn’t have to sign the election
- Contemporaneous records requirement starts in 2020
- Acknowledges that some rentals are mixed use
- The safe harbor election indicates that the rental property is being treated as a trade or business and therefore you must file required 1099’s.
Please contact your CPA at 417-881-0145 if you have any questions about this new guidance.