The determination as to whether a rental real estate enterprise rises to the level of a trade or business under section 162 is difficult, and in many cases unclear. But, it is critical when assessing whether rental real estate activities will qualify for the new 20% section 199A deduction.
To address these uncertainties, the IRS previously released Notice 2019-07, which provided a proposed safe harbor under which a rental real estate enterprise would qualify as a trade or business solely for purposes of section 199A. The IRS finalized this guidance on Sept. 24 with the release of Rev. Proc. 2019-38. While substantially similar to Notice 2019-07, the new revenue procedure does deviate in some notable areas
- Performance of 250 or more hours of rental services – for a rental real estate enterprise in existence for at least four years, at least 250 hours of rental services must have been performed annually in any three of the five preceding tax years. For enterprises that have been in existence less than four years, the hour requirement must be satisfied in the tax year under consideration.
- Triple net leases – the safe harbor is not available to triple net lease arrangements. Under the new guidance, a triple net lease is defined to include a lease that requires the tenant to pay taxes, fees and insurance and to pay for maintenance activities, in addition to rent and utilities. The previous guidance defined triple net leases in a similar manner, but referenced lease agreements where the tenant was responsible for maintenance activities. The revised guidance clarifies that the key factor is who pays for those activities.
- Maintenance of separate books and records – for each rental real estate enterprise, the enterprise must maintain separate books and records. If an enterprise consists of more than one property, this requirement may be satisfied if books and records are maintained for each property and are subsequently consolidated.
- Maintenance of contemporaneous records of rental activities – the enterprise must maintain contemporaneous records documenting the hours, description and dates of all services performed, as well as who performed the services. This requirement is now applicable to tax years beginning after Dec. 31, 2019.
- Attachment to the taxpayer’s timely filed tax return – a taxpayer relying on Rev. Proc. 2019-38 must attach a statement to the return that describes all rental real estate properties included in each rental real estate enterprise for each taxable year in which the taxpayer relies on the safe harbor.
- Taxpayer signature - The revenue procedure eliminates the previous requirement that the taxpayer sign, under penalty of perjury, a statement confirming that all requirements of the safe harbor have been satisfied.
Other items in the revenue procedure are largely unchanged from the prior guidance. For example, in order to qualify for the safe harbor, the taxpayer must hold its interests in each rental real estate enterprise directly or through a disregarded entity. Interests in similar rental real estate properties that fall within the same rental real estate category (such as residential or commercial) may be treated as separate rental real estate enterprises or as a single rental real estate enterprise. However, taxpayers cannot combine residential rental real estate activities with commercial rental real estate activities when establishing their rental real estate enterprises.
Similar to Notice 2019-07, certain types of rental real estate property are not eligible for the safe harbor, including real estate used by the taxpayer as a residence or real estate rented or leased under a triple net lease. Rev. Proc. 2019-38, however, expands upon these exceptions, and includes real estate rented to a trade or business conducted by a taxpayer, which is commonly controlled, as well as rental real estate interests in which a portion is treated as a specified service trade or business for section 199A purposes.
Taxpayers with rental real estate, or those holding interests in a rental real estate enterprises, struggling to determine whether their activities qualify as trades or businesses for purposes of section 199A will likely welcome these finalized safe harbor provisions. But, taxpayers who own an interest in rental real estate should also recognize that this is only a safe harbor. Under appropriate circumstances rental real estate activities that do not satisfy the safe harbor may still constitute trades or businesses for purposes of section 199A.