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Final Regulations under Section 199A Create Safe Harbor for Rental Real Estate, Exclude Triple Net Leases

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Final Regulations under Section 199A Create Safe Harbor for Rental Real Estate, Exclude Triple Net Leases

On January 18, 2019, the Treasury Department and the Internal Revenue Service (IRS) issued final regulations under new Section 199A and three related pieces of guidance.  Created by the 2017 Tax Cuts and Jobs Act (TCJA), Section 199A allows eligible taxpayers (individuals, trusts and estates) to deduct up to twenty (20%) percent of income earned from a qualified “passthrough” trade or business (e.g. sole proprietorship, partnership, LLC, S corporation).  This “QBI deduction” is available in tax years beginning after Dec. 31, 2017, meaning eligible taxpayers will be able to claim it for the first time on their 2018 Form 1040.

Trade or Business Standard: In order to claim the QBI deduction, income must be earned from a qualified “trade or business”.  In proposed regulations issued in August, the IRS clarified the standard to be used in determining the existence of a trade or business was the standard under Section 162.  The Section 162 standard requires a business activity to be conducted regularly and continuously for the primary purpose of earning a profit.  Historically, most business activities outside of isolated or short-term transactions have satisfied the Section 162 standard.  The field where most questions have arisen is the rental of real property.

There is no bright-line rule in statute or caselaw establishing when the rental of real estate rises to the level of a Section 162 trade or business.  Considering the vast number of such businesses, the lack of certainty presented a tremendous challenge to tax professionals, who submitted numerous comments on the issue in response to the proposed regulations.

Safe Harbor for Rental Real Estate: In consideration of these comments, the IRS issued, as part of the guidance for the final regulations, Notice 2019-7.  The Notice contains a proposed revenue procedure (Rev. Proc. 2019-7) providing a safe harbor for certain real estate enterprises that may be treated as a trade or business for purposes of the QBI deduction.

Under Rev. Proc. 2019-7, a rental activity (or multiple rentals if the taxpayer chooses to treat them as a combined enterprise) will rise to the level of a Section 162 trade or business if:

–          Separate books and records are maintained for each rental activity (or the combined enterprise if grouped together),

–          250 hours or more of “rental services” are performed per year for the activity (or combined enterprise), and

–          The taxpayer maintains contemporaneous records, including time reports or similar documents, regarding: (1) hours of all services performed, (2) description of all services performed, 3) dates on which such services are performed, and 4) who performed the services.

For these purposes, rental services include advertising to rent, negotiating and executing leases, verifying tenant applications, collection of rent, daily operation and maintenance, management of the real estate, purchase of materials, and supervision of employees and independent contractors.  Rental services may be performed by owners or by employees, agents, and/or independent contractors of the owners.

Rental services does not include financial or investment management activities, such as arranging financing; procuring property; studying and reviewing financial statements or reports on operations; planning, managing, or constructing long-term capital improvements; or hours spent traveling to and from the real estate.

Certain rental activities are excluded from utilizing the safe harbor:

–          Real estate used by the taxpayer for any portion of the year as a residence; and

–          Any property rented on a triple net basis.

Rev. Proc. 2019-7 defines a triple net lease as 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 includes a lease agreement that requires the tenant or lessee to pay a portion of the taxes, fees, and insurance, and to be responsible for maintenance activities allocable to the portion of the property rented by the tenant.

While triple net leases and taxpayer-used property are not eligible to use the safe harbor, such rental activity may still qualify as a Section 162 trade or business under the normal criteria.  However, the burden will be on the taxpayer to do so, and without the safe harbor, this may be difficult.

The final regulations preserved a special “self-rental” exception provided under the proposed regulations.  Under the exception, which applies only for purposes of section 199A, the rental or licensing of tangible or intangible property to a related trade or business is treated as a trade or business if the rental or licensing activity and the other trade or business are commonly controlled (i.e. more than fifty (50%) percent common ownership).  This exception applies even where the rental is on a triple net lease basis.  Thus, where an operating company leases property from a related property holding company, the rental is considered a per se trade or business for Section 199A purposes, even if it involves a triple net lease (as is often the case).

Takeaways: By creating a safe harbor, the final regulations succeeded in providing to taxpayers who conduct rental businesses much greater clarity on the trade or business requirement of Section 199A.  However, the clarity comes at a significant record-keeping cost, as taxpayers must keep separate books and records for each activity, and detailed, contemporaneous records documenting at least 250 hours of rental services for each activity.

Further, the exclusion of triple net leases from the safe harbor means many landlords may be unable to claim the QBI deduction on their rental income.  Taxpayers in that situation should contact their advisers to determine whether and if their lease arrangements can be modified to take advantage of the safe harbor.

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