Neil V. Birkhoff

Neil V. Birkhoff
Principal

Recently, the Internal Revenue Service released final regulations under Section 199A, a section in the Internal Revenue Code introduced with the 2017 Tax Act. These regulations provide a deduction to a non-corporate taxpayer for up to 20% of the qualified business income from each of the taxpayer’s qualified trades or businesses, including those operated through a partnership, S corporation, or a sole proprietorship. The deduction applies in tax years 2018 through 2025. Along with the release of the final regulations, the IRS released Notice 2019-07. The notice contains proposed safe harbor rules for determining when a rental real estate enterprise may be treated as a trade or business for the Section 199A deduction.

To qualify for a Section 199A deduction, a trade or business must not be specifically disallowed by the regulations or performing services as an employee. Section 199A regulations define a trade or business as a trade or business under Section 162 (the business expense rules). The regulations allow rental activity that does not rise to the level of a Section 162 trade or business to be treated as a trade or business for purposes of Section 199A. The property in question must be rented or licensed to a trade or business that is under common control with a Section 162 trade or business.

As noted above, Notice 2019-07 provides a safe harbor that allows a rental real estate enterprise to be treated as a trade or business solely for purposes of the Section 199A 20% deduction. To qualify for a proposed safe harbor, a taxpayer must meet all of the following requirements:

  • Maintain separate books and records for each rental enterprise
  • Spend 250 hours or more on each rental enterprise (as specified in the Notice)
  • Maintain concurrent records including hours, description, dates, and persons performing services, except for tax years beginning prior to 2019

The taxpayer also must submit a statement, under penalties of perjury, with the federal income tax return on which the claims that these Section 199A deduction requirements have been satisfied.

To satisfy the 250-hour requirement, a taxpayer either may treat every property held for the production of rent as a separate rental enterprise, or treat all similar properties as a single rental enterprise. For purposes of the safe harbor, rental real estate enterprises are defined as interests in real property held for the production of rent. To be treated as part of a single enterprise, the interest in real property must be held directly or through entities disregarded as separate from their owners (single-member limited liability companies). Thus, an interest in a partnership that holds rental real estate may not be treated as a rental enterprise for the taxpayer holding the partnership interest. Further, residential and commercial properties cannot be combined as a single rental enterprise for purposes of the safe harbor rules.

Real estate used by the taxpayer as a residence for any part of the year and triple net leases (as described in the Notice) are specifically excluded from the safe harbor rules. The 250-hour requirement may include time spent by independent contractors on rental activities. However, it does not include construction time or time spent on financial or investment management activities.

Issuing Notice 2019-07 along with the final Section 199A regulations indicates the Treasury Department recognizes that landlords need more certainty regarding their ability to take the 20% deduction. However, the scope of the proposed safe harbor (in lieu of a complicated Section 162 trade or business analysis) is unclear as a result of the 250-hour minimum, triple net lease exclusion, and the inability to aggregate residential and commercial real estate enterprises.

If you have any questions concerning the proposed safe harbor under Section 199A for rental real estate activities, or any other questions regarding the qualified business income deduction, please contact one of the attorneys in the Tax Group at Woods Rogers. As always, the Tax Group will monitor developments regarding Section 199A.