On Friday, January 18, 2019, the Treasury Department issued final rules under IRC Section 199A. As part of this regulation package, Treasury also provided much-needed relief and clarity for rental real estate activities.
IRS Section 199A is a tax incentive for pass-through entities and sole proprietorships. It effectively reduces the federal tax rate on income arising from certain activities by as much as 20%. However, Section 199A only applies to an activity that is a “trade or business.” This is a term that is not clearly defined by the IRS (shocking, I know) and there is also vague guidance in case law. In general, the case law would suggest that many real estate activities might not qualify under this definition. Real estate owners, developers and investors thus faced uncertainty as to whether the incentives under 199A would apply to them.
The Safe Harbor – General
On January 18, 2018, the government issued final regulations and in addition announced a Revenue Procedure that carves out a safe harbor for rental real estate. The gist of the proposed relief is to create a safe harbor under which rental real estate will be treated as a trade or business for purposes of 199A. Thus, operations that meet the safe harbor will qualify for the incentive and the profits from such operations will be taxed at lower rates.
The safe harbor sets out three main requirements that must be met and includes several exclusions or caveats. I address each of these in detail below.
The Safe Harbor – Specific Requirements
The safe harbor sets out three requirements:
- Separate books and records must be maintained to reflect income and expenses for each rental real estate enterprise.
- At least 250 hours of rental services must be performed each year with respect to each rental enterprise.
- The taxpayer must maintain contemporaneous records, including time reports, logs, or similar documents, regarding the following: (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. Such records must be made available for inspection at the request of the IRS.
Because most businesses already maintain separate books for each real estate activity, the first requirement should be easy to satisfy.
The second and third requirements may be more difficult to meet. Note that an extensive definition of “rental services” is set forth in the safe harbor. Specifically, rental services include:
(i) advertising to rent or lease the real estate;
(ii) negotiating and executing leases;
(iii) verifying information contained in prospective tenant applications;
(iv) collection of rent;
(v) daily operation, maintenance, and repair of the property;
(vi) management of the real estate;
(vii) purchase of materials; and
(viii) supervision of employees and independent contractors.
Moreover, rental services can be performed by owners, employees, agents, and/or independent contractors of the owners. Thus, unlike the passive activity rules that require the taxpayer or a spouse to work a certain number of hours in the activity each year, this requirement is met even if the services are carried out by a third party. Accordingly, it will become very important that vendors who perform services that could be counted towards the 250-hour requirement provide documentation. As a property manager, you serve as a vendor of your owner. You already provide them with financial statements each month. The issue though is that your owner would have to prove the hour requirement that was spent on each property and I have many property managers who have fielded calls in regard to this. The problem is that for a property manager to comply with this request, they would need to hire a team of accountants and say goodbye to any profitability and any life whatsoever as you will be working 24-7 trying to comply. Many property managers thus have incorporated a policy that they do not provide the hourly requirement report for purposes of IRS Section 199A. Generally, they place this in their property management agreement.
Although the above list is not stated as exclusive, the safe harbor specifically excludes 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.
The 250-hour requirement is an annual requirement, but the safe harbor relaxes this starting in 2023. At that point, the 250-hour requirement need only be satisfied in any three of the five consecutive years ending with the taxable year.
Finally, the contemporaneous documentation requirement does not appear to apply to the 2018 tax year, but that the 2018 documentation can be created after the fact.
The Safe Harbor – Exclusions
The safe harbor sets out several exclusions, each of which is addressed below.
- The safe harbor only applies to rental real estate.
- The safe harbor does not apply to triple net leases.
- The safe harbor does not apply to owner residences.
The safe harbor grouping rules.
The safe harbor contains a grouping rule that can both help and hurt taxpayers. In general, a taxpayer must either (a) treat each property held for the production of rents as a separate enterprise, or (b) treat all similar properties held for the production of rents as a single enterprise. This would help taxpayers in cases where the 250-hour requirement cannot be satisfied for individual rental arrangements but can be satisfied on an aggregate basis. However, the safe harbor goes on to stipulate that commercial and residential real estate may not be aggregated.
The safe harbor may be very helpful for some taxpayers, but it also creates new challenges. If you have any questions regarding this information, please contact me directly.