Real property-related tax questions have long been a mainstay of this blog. Since being passed into law in late 2017, the Tax Cuts and Jobs Act and its sections relating to investment in commercial real estate have regularly appeared in my posts. The establishment of tax-advantaged Opportunity Zones and the clarifications of the regulations governing those investments, among other aspects of that legislation, have also been of particular interest in these articles.
Another feature of the TCJA that I have written about here has been the 20% qualified business income deduction allowed under Section 199A for certain “passthrough entities” (business organizations that are not taxed separately but “pass through” their gains and losses, e.g., limited liability companies, S corporations, and partnerships, as well as sole proprietorships). My blog has previously examined the questions that have been raised about the effect this law could have on real estate investment and development. Recently, following up on proposed rules published earlier this year, the IRS has now announced its final safe harbor rules under which taxpayers holding interests in rental real estate (including mixed-use property) may qualify for this 20% deduction, clarifying those circumstances under which such rental real estate activity shall rise to the level of a trade or business.
Under these new safe harbor rules, a taxpayer or a relevant passthrough entity that engages in a rental real estate enterprise meeting all the following requirements shall be entitled to take the 20% qualified business income deduction pursuant to IRC Section 199A:
- Separate books and records must be maintained for each rental real estate enterprise.
- At least 250 hours of rental services must be performed per year for each rental real estate enterprise.
- Contemporaneous records of services performed must be kept by the taxpayer or passthrough entity, including time reports, logs, or similar documents, keeping track of the hours of services performed and describing all services performed, the dates of performance, and who performed the services.
- A certification stating that the safe harbor rules have been followed must be attached to the tax return of the taxpayer or passthrough entity.
For the sole purpose of qualifying for this safe harbor, a rental real estate enterprise is defined as one or more interests in real property held for the production of rents, either directly or through a disregarded entity such as a single-member limited liability company. The taxpayer or passthrough entity seeking to take advantage of this safe harbor must hold each interest in real property either directly or through a disregarded entity. The taxpayer’s residence, triple net leased property, and real estate rented to a trade or business conducted under common control by the taxpayer are not eligible for the safe harbor.
In addition to the foregoing safe harbor rules, the following requirements have been established for taxpayers to satisfy these safe harbor rules:
- With respect to the “separate books and records” requirement, if a rental real estate enterprise includes more than one property, this requirement is met if separate income and expense records are kept for each property and then consolidated.
- With respect to the “250 hours of rental services” requirement, rental real estate enterprises in existence for less than four years must meet this requirement for each year of existence; for rental real estate enterprises in existence for at least four years, this requirement must be met in at least three of the past five years. For purposes of this requirement, “rental services” include, without limitation, advertising to rent or lease the property, negotiating and executing leases, collecting rent, operating, maintaining and repairing the property, managing the property, and supervising employees and independent contractors, but does not include financial or investment management activities, studying and reviewing financial statements or reports of the property, improving the property, or traveling to and from the property.
- With respect to the “contemporaneous records of services performed” requirement, if the services are performed by employees or independent contractors, with respect to such employees or independent contractors, the taxpayer is allowed to provide a description of the services performed, the amount of time generally spent performing such services, and time, wage or payment records, which must be made available for inspection at the IRS’s request.
- With respect to the certification requirement, the statement to be attached to the tax return must include a description of all rental real estate held by the enterprise, the addresses of the properties and the rental category of each property, and a representation that the requirements of this safe harbor have been satisfied.
In addition, the IRS has noted that, even if a rental real estate enterprise fails to satisfy the safe harbor requirements, it may still be entitled to take the 20% qualified business income deduction if it otherwise meets the definition of a qualified trade or business under Section 199A and its regulations. It should be kept in mind, however, that as a practical matter, such qualification would be more challenging than satisfying the safe harbor rules. In view of these safe harbor rules, it would seem likely that taxpayers will take all reasonable steps to satisfy these requirements.
The text of these new IRS safe harbor rules may be found here.