IS your rental a trade or business (IRC Sec 199A/QBID/20% Deduct)

[Eamonn McElroy]

BP Community,

247 pages of final IRC Sec 199A regulations, 39 pages of new proposed IRC Sec 199A regulations, a new Revenue Procedure related to W-2 wage calculation for 199A purposes, and a proposed Revenue Procedure putting forth a new safe harbor procedure for a rental real estate trade or business determination were released today, a Friday, between 3:30 and 4:51 pm EST causing quite a commotion on what would normally be an ordinary, pre-busy season Friday for most tax accountants.  It's safe to say the Treasury wants to keep us on our toes.

Although there have been a few posts on the subject already, I'd like to add my own summary and thoughts on the last item released, which is very pertinent to investors here on BP...

Notice 2019-07 notifies taxpayers that the Treasury has issued a proposed Revenue Procedure which gives taxpayers a safe harbor option for a 'trade or business' determination for their rental real estate.  It was released today (a Friday) at 4:51pm EST and gave east-coast tax pros the excuse they needed to stay in the office well past closing time.  For safe harbor purposes, it also introduces the term "enterprise" for making a 'trade or business' determination on rental real estate.

Who may use the safe harbor method?

Individuals and 'relevant passthrough entities' (RPE).  RPEs are partnerships and S Corps with at least one direct or indirect individual, estate, or trust owner, and some estates and trusts to the extent they pass through items of QBI.

What qualifies as a rental real estate enterprise?

A rental real estate 'enterprise' is an interest in property held for the production of rents.

An individual or RPE must hold the interest in property directly or through a 'disregarded entity'.

Taxpayers must treat each interest in a rental real estate property as a separate enterprise, or must treat all "similar" properties as a single enterprise.  Commercial real estate and residential real estate may not be combined into an enterprise.  Taxpayers may not vary their choice of treatment year-over-year unless there has been a "significant" change in facts and circumstances.

Real estate used by the taxpayer as a residence for any part of the year is not eligible for the safe harbor and is not includable in any 'enterprise'.

What must taxpayers do to qualify for the safe harbor?

(1) Separate books and records must be maintained to reflect income and expenses for each 'enterprise'.

(2)(i) For tax years prior to January 1, 2023, 250 or more hours of "rental services" are performed per year with respect to the rental enterprise.

(2)(ii) For tax years beginning after December 31, 2022, 250 or more hours of "rental services" are performed in any three of the five consecutive taxable years that end with the taxable year (or in each year if an enterprise was held less than five years) with respect to the rental enterprise.

(3) For tax years beginning after December 31, 2018, the taxpayer maintains records which detail (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.

(4) Taxpayers must attach a signed statement to their tax return for the tax year they are both eligible for and wish to claim the safe harbor.

What the heck are "rental services"?

Rental services, for purposes of the safe harbor include:

(1) Advertising to rent or lease the enterprise.

(2) Negotiating and executing leases.

(3) Verifying information contained in prospective tenant applications.

(4) Collection of rent.

(5) Daily operation, maintenance, and repair of the property.

(6) Management of the real estate.

(7) Purchase of materials.

(8) Supervision of employees and independent contractors.

It is extremely important to note that these rental services, for purposes of the safe harbor, may be performed by owners or employees, agents, and/or independent contractors of the owners.  This means that generally speaking hours of property managers, painters, lawn maintenance crews, etc would fall under the purview of the safe harbor and would count toward an owner's 250 hour goal.  This is very favorable to the taxpayer and creates a very low bar for 'trade or business' determination in my opinion.  Not afraid to say I'm pleasantly surprised by this addition and hope it remains in the potential final Rev Proc.

What does not count as a "rental  service"?

"Rental services" do not include financial or investment management activities such as:

(1) Arranging financing.

(2) Procuring property.

(3) Studying and reviewing financial statements or reports on operations.

(4) Planning, managing, or constructing long-term capital improvements.

(5) Hours spent traveling to and from the real estate.

Other notes:

(1) If an 'enterprise' fails to satisfy the requirements of the Rev Proc, it may still be treated as a 'trade or business' for IRC Sec 199A if it qualifies as an IRC Sec 162 'trade or business'.  Note this is the determination we were making and expecting to make prior to the new safe harbor, so it's not new or unexpected.

(2) The proposed Rev Proc is just that, a proposed Rev Proc.  It is not final yet and changes may be made between now and finalization, however Notice 2019-07 explicitly states that until it is made final, taxpayers may use the safe harbor described in the proposed Rev Proc for purposes of determining when a rental real estate 'enterprise' may be treated as a 'trade or business' solely for purposes of IRC Sec 199A.  This means we can use the safe harbor for 2018 tax year returns.