The Treasury Department and the IRS recently issued Revenue Procedure 2019-38, providing a safe harbor under which certain rental estate activities will be treated as a trade or business solely for purposes of the new pass-through deduction regime Section1 199A.2 The revenue procedure finalizes proposed guidelines released in January,3 discussed here, and sets forth the procedural requirements for using the safe harbor. A failure to satisfy the requirements of this safe harbor does not preclude a taxpayer from otherwise establishing that an interest in rental real estate is a trade or business for purposes of Section 199A. Taxpayers relying on the safe harbor may be entitled to a 20 percent deduction for net rental income (but not capital gains) derived from a qualifying enterprise under Section 199A. However, taxpayers should be aware that claiming that a rental real estate enterprise is a trade or business may have unexpected consequences, such as additional reporting and, in certain cases, a limitation on the deductibility of interest expense.
Under the safe harbor, a rental real estate enterprise is defined as an interest in real property held for the production of rents and may consist of an interest in multiple properties. A taxpayer must treat each property separately or all similar properties, in general, as a single enterprise. Commercial and residential properties must be treated as separate enterprises. Once a taxpayer treats similar properties as a single enterprise under the safe harbor, the taxpayer must continue to treat interests in such properties, including newly acquired properties in the same category, as a single enterprise. However, if a taxpayer chooses to treat each property as a separate enterprise, it may in the future elect to treat all similar commercial or residential properties as a single enterprise.
The revenue procedure adds a new rule providing that mixed-use property (single building with residential and commercial units) may be treated as a single enterprise or bifurcated into separate residential and commercial interests. Mixed-use property that is treated as a single enterprise cannot be combined with other residential, commercial or mixed-use property. A rental real estate enterprise will be treated as a trade or business if the following requirements are satisfied during the particular tax year:
- Separate books and records must be maintained to reflect income and expenses for each rental real estate enterprise. The revenue procedure clarifies that if an enterprise contains multiple properties, this requirement may be satisfied if income and expense statements for each property are maintained and then consolidated.
- 250 or more hours or rental services must be performed per year with respect to the rental real estate enterprise for enterprises that have been in existence less than four years. For enterprises that have been in existence for at least four years, 250 or more hours per year must be performed with respect to the enterprise in at least three of the past five tax years.
- The taxpayer must maintain contemporaneous records that include (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. The revenue procedure postpones the effective date of this requirement until taxable years beginning on or after January 1, 2020. It also simplifies the recordkeeping requirement for services performed by an employee or independent contractor. In lieu of recording all work dates and hours of services performed, the taxpayer may simply provide the amount of time the service provider generally spends performing the services, and time, wage or payment records.
- The taxpayer must attach a statement to a timely filed original return (or an amended return for the 2018 tax year only) for each year the taxpayer relies on the safe harbor. The statement must describe the properties included in each enterprise and any properties acquired and disposed of during the year, and include a representation that the requirements above have been satisfied.
As in the proposed guidelines, the safe harbor does not apply to real estate used by a taxpayer as a residence or to real estate rented under a triple net lease. The revenue procedure also excludes from the safe harbor (i) real estate leased to a trade or business conducted by a taxpayer or a relevant pass-through entity that is commonly controlled (presumably because final regulations already treat such rental activity as a trade or business for purposes of Section 199A), and (ii) real estate rented to a specified service trade or business with 50 percent or more common ownership.
Rental services
The revenue procedure provides a list of qualifying and non-qualifying rental services (set forth below) that is virtually identical to the list included in the proposed safe harbor.
| Qualifying rental services | Non-qualifying rental services |
|---|---|
| Management of the real estate, including rent collections and supervising service providers | Financial and investment management activities, including arranging financing, reviewing financial statements and reports on operations |
| Negotiating leases and verifying information contained in tenancy applications | Planning, managing or constructing long-term capital improvements |
| Advertising to rent or lease the real estate | Hours spent traveling to and from the real estate |
| Daily operation, maintenance and repair of property | |
| Purchase of materials and supplies |
Effective date
The revenue procedure applies to taxable years ending after December 31, 2017. For the 2018 tax year, taxpayers may rely on the safe harbor described above or the proposed guidelines released in January.
Footnote
1 All "Section" references are to the Internal Revenue Code of 1986, as amended.
2 See Rev. Proc. 2019-38.
3 See Notice 2019-07, 2019-09 IRB 740.
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