The Section 199A deduction requires you to be a trade or business. Follow these rules to take advantage of this generous deduction on your rental properties.
The IRS released final regulations on 199A. The Kiplinger Tax Letter said it best: “Final regulations provide limited guidance, but IRS gives a safe harbor.”
In this post we will discuss the safe harbor as it relates to “trade or business” with special emphasis on application with rental properties. The safe harbor doesn’t apply to all taxpayers and the trade or business designation is still possible without meeting the safe harbor parameters.
The final regulations run 248 pages. I will follow this post with a detailed post on 199A tiers with several decision trees. Due to the length and complexity of the regulations we are forced to remain focused on one aspect of 199A. Taxpayers with a sole proprietorship, partnership, S corporation or investment property may wish to seek the services of a competent tax professional until more clarification is reached through more regulations or from the Tax Court.
Links are provided at the end of this post to the entire 248 pages of regulations released and Notice 2019-07 (only 10 pages!) dealing with the trade or business safe harbor for real estate issues for your further research.
Remaining Problems with the Final Regulations
The final regulations refer to Section 162 (as previous releases have). Section 162 generally governs the deductibility of expenses for a trade or business. But Section 162 is unclear when it comes to rental activities.
The reason for the vagueness is because the facts and circ*mstances of each taxpayer differs. Whether the property is commercial or residential, the lease terms, services provided, how many properties owned and day-to-day involvement in the activity all play a role. We will touch on each of these throughout this post.
The biggest problem with the final regs is that they were issued after 2018 was in the books. Nobody knew they needed to keep track of time spent in the activity, nor did they know they were required to keep a separate bank account for the rental activity.
The IRS, aware of this, has granted some leeway for the 2018 tax return as it regards contemporaneous records. However, for tax years beginning after December 31, 2018 you must follow the new regs for record keeping. Ignorance is not an excuse.
Once the IRS laid out the safe harbor for a “rental real estate enterprise” they state:
Failure to satisfy the requirements of this safe harbor does not preclude a taxpayer from otherwise establishing that a rental real estate enterprise is a trade or business for purposes of
section 199A.
This means the safe harbor isn’t the only way to take advantage of the generous 199A deduction.
If you use the safe harbor you must include a statement to that effect with the tax return. Qualified pass-through entities (RPEs) can also use the safe harbor and provide the taxpayer with the required statement that application of the safe harbor was used as outlined by regulations. This is attached to your return.
Safe Harbor
Rental Real Estate Enterprise: For purposes of the safe harbor the IRS uses the term rental real estate enterprise, defined as an interest in real property held for the production of rents and may consist of an interest in multiple properties.
The individual or pass-through entity relying on this safe harbor must hold the interest directly or through a disregarded entity. This means you can only use the safe harbor if you hold the property personally or as an LLC treated as a disregarded entity. If you hold the property in an LLC electing to be treated as an S corporation (and there is no reason to ever hold real estate in an S corp) you cannot use the safe harbor.
The taxpayer must treat the property (or group of properties) held for the production of rents as a separate enterprise. This means you hold each property or group of properties as a single enterprise. Which means you have a separate bank account and name for the enterprise. Those with multiple LLCs could experience issues with qualifying for the safe harbor.
Commercial and residential property cannot be part of the same enterprise. Yes, this can cause real confusion when you have mixed property under one LLC and/or business name. As I read this regulation you would need to qualify for the safe harbor for both the residential and commercial property.
Once you establish a treatment for your properties (which properties belong with each enterprise) you must continue with the same treatment unless there has been a significant change to the facts and circ*mstances (sale or purchase of property, for example).
Safe Harbor Defined:For the Qualified Business Income Deduction only, a rental real estate enterprise will be treated as a trade or business if the following requirements are satisfied during the taxable year with respect to the rental real estate enterprise:
- Separate accounting of income and expenses are maintained for the rental real estate enterprise.
- 250 or more hours of rental services are performed for taxable years beginning prior to January 1, 2023 with respect to the rental enterprise.
- For taxable years beginning after December 31, 2022, 250 or more hours performed in respect to the rental real estate enterprise in any 3 of the 5 prior consecutive years.
- Contemporaneous records are required, including: time reports, logs and similar documents regarding the following:
- hours ofall services performed
- description ofall services performed
- dates services were performed, and
- who performed the services
Of course, contemporaneous records are a bit hard to produce when the rules were not in place until after the tax year concluded, and therefore the records do not need to be contemporaneous for tax year 2018. I recommend going over 2018 ASAP to create a log of all services performed.
What Counts for the Safe Harbor
Not all activities count toward the 250 hour requirement for the safe harbor.
Rental services performed by the taxpayer or by employees, agents, and/or independent contractors of the taxpayer all count toward the 250 hour safe harbor requirement.
Rental services for the rental real estate safe harbor include:
- advertising to rent or lease the property/s
- negotiating and executing leases
- verifying information from prospective tenants
- collection of rents
- daily operation, maintenance and repair of the property/s
- management of the property/s
- purchase of materials
- supervision of employees and independent contractors.
Keep in mind the time supervising employees and/or contractors only includes your time supervising. The hours performing services by employees and independent contractors do not count toward your hours.
Activities that Don’t Count as Rental Services
Several activities donotcount as rental services as applied to the 250 hour requirement:
- travel to and from the property/s
- financing activities
- investment management activities (financial statement review; property search; and procuring and planning, managing or constructing long-term capital improvements)
Generally, things that are easily fudged are disallowed. Saying you spent many hours reviewing the books or driving to the property will not benefit you. Saying you spent x number of hours planning capital improvements to the properties also do not count toward the safe harbor.
Other Exclusions
Several situations are excluded from using the safe harbor.
Any personal use of the property during the year excludes use of the safe harbor.
Triple-net leases are also excluded from the safe harbor. A triple-net lease is defined as a lease agreement that requires the tenant to pay for all or part of the taxes, fees and insurance, and the tenant is responsible for
maintenance requirements in addition to rent and utilities. Since most commercial property is leased triple-net, the safe harbor option is unavailable, but may still qualify as a trade or business as shown next.
How to Still Claim as a Trade or Business
Since so many tax dollars are riding on the line it is important to determine if you qualify for the 199A deduction. The safe harbor is just that, a safe harbor. Just because you don’t qualify for the safe harbor does not mean you do not have a trade or business.
There are some similarities in this safe harbor with the material participation tests under the passive activity rules. While the numbers between this safe harbor and the material participation tests are different, we can still gather guidance by reviewing the facts and circ*mstances in determining if the activity is a trade or business.
Earlier last summer while waiting for the IRS to provide guidance on what a “trade or business” is, I decided to build a policy for my office. My conclusion was that investment property (reported on Schedule D when sold) was not a trade or business and property that is treated as a sale of business property when sold (reported on Form 4797) is a trade or business. With the recent IRS guidance I am forced to tighten my definition of a trade or business in situations not covered by the safe harbor.
The IRS actually uses the words “trade or business activities” in their material participation tests. In other words, they say:
You materially participated in a trade or business activity for a tax year if you satisfy any of the following tests:
Whereas the safe harbor for 199A rental services say you need 250 hours, the first material participation test says 500 hours. I think it is safe to say we can use 250 hours when not using the safe harbor as well.
But you can still be a trade or business if you put in fewer than 250 hours if the material participation tests are a valid ancillary.
Material participation test #3 says if you put in 100 hours, and is more than anyone else in the activity, you pass the test and materially participate.
According to test #2, if you put in substantially all the participation in the activity you pass.
There are additional tests to determine material participation. For trade or business issues I think it is reasonable to use the material participation guidelines, whether it be a small business or rental property. The safe harbor is a bit easier to pass for 199A based on hours, but if you meet the guidelines in any of the material participation tests you have substantial grounds for claiming you are a trade or business since the IRS already recognizes this in another area of tax application.
Final Considerations
Section 199A, the Qualified Business Income deduction is one of the most complex pieces of legislation to hit taxpayers in a long while. I dealt with one narrow subsection of the regulations.
It might be a good idea to hire a tax professional for at least one year if you own a business and or rental property to deal with the litany of tax issues surrounding 199A. Even if an extension is required and your taxes are not filed until later in the year.
Here are a few issues not covered in this post that you will want to discuss with your tax professional:
- Tier #1, #2 and #3 for small businesses
- Specified service trades or businesses (SSTB)
- Form 1099 (If a rental in not a trade or business then Form 1099 reporting can sometimes be avoided. However, you want to be a trade or business for 199A reasons so if you don’t file Form 1099 with contractors the IRS may disallow the deduction because you didn’t act like a trade or business)
- Contributed property to an entity has special rules
- Special rules apply to like-kind exchanges and involuntary conversions
- Special considerations for basis of inherited property
- Net operating losses affect 199A
- Capital gains and losses may affect 199A
- Amended returns are not allowed to initiate aggregation, but aggregation can be used in future years
- SSBTs are better defined in the final regulations
- and more. . .
As promised, here are the reports from the IRS. You can read Notice 2019-07 as well as I. It is a short 10 page document and worth a read if you have rental properties. Less readable is the final regulations on 199A, coming in at 248 pages.
If you ever have trouble falling a sleep one evening just pick up the final regs. You’ll be out cold in minutes.
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