RENTAL REAL ESTATE, WHEN DOES IT QUALIFY FOR SEC. 199A DEDUCTION?

On January 18, 2019, the IRS issued final regulations on a number of Sec. 199A issues. The final regulations establish a prerequisite whereby a business must first arise to the level of a “Section 162 trade or business” before it is capable of producing income eligible for the 20% deduction. For many active, profit-seeking businesses, this requirement hasn’t been difficult to meet, but the Section 162 standard has become problematic for rental real estate.

The IRS also issued Proposed Revenue Procedure 2019-7 to offer a safe harbor. A rental activity is defined as a single rental or multiple rentals if the taxpayer chooses to group either commercial properties or residential properties to treat them as a combined enterprise(s). Each rental activity will rise to the level of a Section 162 trade or business and be eligible for the 20% deduction if:

  • Separate books and records are maintained for each rental activity;
  • For tax years beginning prior to 2023, 250 or more hours of rental services are performed (as described below) annually for the activity. For tax years beginning after 2022, the 250 hour rules applies in any three of five consecutive tax years; 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.
    • The contemporaneous records requirement will not apply to the 2018 tax year.

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.

The safe harbor is not available for the rental of a residence the taxpayer uses as a personal residence for more than 14 days.

What about a triple net lease? A taxpayer can’t use the safe harbor for any property rented on a triple net basis. For purposes of the proposed revenue procedure, a triple net lease includes a lease agreement in which the tenant or lessee is solely responsible for paying taxes, fees and insurance, in addition to base rent and utilities.  However, the final regulations make it clear that just because property rented on a triple net basis can’t use the safe harbor, it doesn’t necessarily prevent the taxpayer from arguing that the rental rises to the level of a Section 162 trade or business based on the facts and circumstances.

One exception is provided in the final regulations to the trade or business requirement for rentals: A rental activity will be treated as a Section 162 trade or business if it is rented to a ‘commonly controlled’ trade or business owned by the taxpayer. Therefore, a self-rental is granted de facto Section 162 status, even if the activity might not have otherwise satisfied that standard.

To be ‘commonly controlled,’ the property must be rented to an individual or pass-through (not a C corporation), and the same owner or group of owners must own 50% or more of both the property and business.

Please contact our office to evaluate how these rules impact your tax situation.