Qualifying a Rental Real Estate Operation for the 199A Deduction

January 8, 2020 — Under the Tax Cuts and Jobs Act, a 20% qualified business income deduction was granted to individuals and qualifying pass-through entities under IRC section 199A. Due to a large number of rental real estate operations owned either individually, or through a pass-through entity model, many questions have been raised regarding whether rental real estate operations qualify for the additional deduction.

Background

The IRS recently updated the IRC Section 199A frequently asked questions (FAQ) and specifically addressed rental real estate operations.  In the FAQ, the IRS provided three methods for a rental real estate operation to qualify for the 20% qualified business deduction. To qualify:

1. The rental operation must rise to a trade or business level under IRC 162
2. The rental operation must be to a commonly controlled trade or business operated by an individual or a pass-through entity
3. The rental operation must qualify for the “safe harbor” under Revenue Procedure 2019-38

Qualifying trade or business under IRC 162

Qualifying as a trade or business under IRC 162 is dependent upon all the facts and circumstances surrounding the rental. In practice, this can prove to be difficult to determine as the Internal Revenue Code does not provide a definition of what a qualifying trade or business is. However, with the support of case law, we know that the taxpayer must be involved in the rental operation with continuity and regularity and that the purpose of engaging in the rental operation must be for profit. Other factors to rely upon in determining whether a rental operation rises to the level of a trade or business include:

1. The taxpayer’s efforts to rent the property
2. The maintenance and repairs supplied by the taxpayer
3. The taxpayer’s employment of labor to manage the property or provide services to the tenants
4. The purchase of materials, payment of expenses, and the collection of rent by the taxpayer

If the rental is structured as a “Triple Net Lease”—meaning the tenant agrees to pay for the property taxes, insurance, and property maintenance—there can be difficulty in claiming the rental as a trade or business under IRC 162. Along with this, triple net leases do not qualify for the safe harbor listed under Rev. Proc. 2019-38. A single triple net lease rental will generally not rise to the level of a trade or business.

Qualifying self-rentals

The rental of property is automatically treated as a trade or business for the 20% qualified business income deduction if the property is rented to a business that has 50% or more common ownership. For this rule to apply, the same person or group of people must own—either directly or indirectly—both 50% or more of the rental activity and the operating trade or business. Please note that the operating trade or business cannot be a C Corporation to be considered a qualified self-rental.      

Revenue Procedure 2019-38

If taxpayers are uncertain whether their rental operation will qualify as a trade or business under IRC 162, they can look to the Revenue Procedure 2019-38 for a safe harbor. One important item to note regarding this safe harbor is that if a rental operation rises to the level of activity required to satisfy the safe harbor, then the rental operation will almost certainly be considered a trade or business under IRC 162. 

To qualify for the safe harbor provided under this Rev. Proc., all the following requirements must be met by the rental real estate enterprise during any given tax year: 

1. Separate books and records must be maintained to reflect income and expenses.
2. For any rental real estate enterprise in existence less than four years, 250 or more hours of rental services must be performed each year. For any rental real estate enterprise in existence more than four years, in any three of the five consecutive taxable years ending with the taxable year, 250 or more hours of rental services must be performed each year.
3. Beginning in 2020, the taxpayer must maintain contemporaneous records, including time reports, logs, or other similar documents regarding the following for employees and independent contractors:
   1. Hours of services performed
   2. Description of services performed
   3. Dates on which such services were performed
   4. Who performed the services
4. The taxpayer must attach a statement to their tax return for each year in which they rely upon the safe harbor to take the 20% qualified business deduction. The statement must list a description of the rental properties included under the safe harbor.

A rental real estate enterprise is defined by Rev. Proc. 2019-38 as a directly held interest in a single property or multiple properties held to produce rents. Taxpayers may treat all interests as separate interests or group similar interests as a single rental real estate enterprise. However, properties are only considered similar if they are part of the same rental real estate category. The two allowed categories to combine properties into a single enterprise are residential and commercial. This could provide opportunities to group similar properties to qualify for the safe harbor.

The finalized revenue procedure also added sections to address the treatment of mixed-use property. If a single building contains both residential and commercial units, the building may be treated as a single rental enterprise or it may be bifurcated into separate residential and commercial interests. However, if this mixed-use property is treated as a single rental enterprise, it may not be combined with any other property for purposes of meeting this safe harbor requirement.

Under this Revenue Procedure, rental services may be performed by owners or by employees and independent contractors of the owners. They include the following qualifying activities:

1. Advertising for rent or lease
2. Negotiating and executing leases
3. Verifying tenant applications
4. Rent collection
5. Daily operation, maintenance, and repair of property
6. Management of the real estate
7. Supervision of employees and independent contractors

Rental services do not include the following activities:

1. Arranging financing
2. Procuring property
3. Reviewing financial statements
4. Making improvements to the property beyond normal repairs
5. Time spent traveling to and from the real estate

Lastly, the following real estate arrangements are excluded from the safe harbor all together:

1. Real estate used as a residence for any part of the year
2. Real estate subject to a triple net lease (i.e., a lease agreement where the tenant is required to pay the taxes, fees, insurance, and maintenance associated with the property)
3. Real estate rented to a business with common ownership (i.e., a self-rental). A self-rental is automatically deemed eligible for the 20% deduction under a separate ruling
4. Real estate where any portion of the interest is treated as a “specified service trade or business”

Conclusion

If you have any questions regarding whether your rental real estate operation will qualify for the 20% qualified business income deduction, please contact Alex Toninato at atoninato@redpathcpas.com or (651) 407-5883.