Tax Strategy: Rental real estate and the QBI deduction
One of the most confusing aspects of the 20 percent qualified business income deduction enacted as part of the Tax Cuts and Jobs Act — and one that is an issue even for pass-through owners under the income thresholds that avoid many of the other difficult issues under Code Sec. 199A — is whether their rental real estate activity qualifies as a trade or business for purposes of the deduction.
Individual taxpayers may have typically been reporting that activity on Schedule E rather than Schedule C, which might imply that it is an investment activity rather than a trade or business. There is some authority that a Schedule E activity can be treated as a trade or business for tax purposes, but the issue is not settled.
To assist taxpayers in addressing this issue, the IRS issued a proposed safe harbor in Notice 2019-07 to provide taxpayers with real estate activity clear guidance on the requirements to safely qualify as a trade or business for qualified business income deduction purposes.
Now, after reviewing comments received in response to the notice, the IRS has finalized the safe harbor in Rev. Proc. 2019-38. The safe harbor is on the whole favorable in permitting real estate activity to qualify as a trade or business under the deduction.
Rev. Proc. 2019-38
Revenue Procedure 2019-38 follows fairly closely the procedures set forth in Notice 2019-07 with a few changes. The safe harbor may be used by taxpayers and relevant pass-through entities, as defined in the regulations for the qualified business income deduction, who own a direct interest, or an interest through a disregarded entity, in a rental real estate enterprise. A “rental real estate enterprise” is an interest in real property held for the production of rents and that may consist of an interest in a single property or interests in multiple properties.
In a change from Notice 2019-07, taxpayers and relevant pass-through entities may treat each interest in similar property as a separate rental real estate enterprise or treat interests in all similar properties as a single rental real estate enterprise. Residential property is not viewed as similar to commercial property. An interest in a mixed-use property, with both residential and commercial elements, may be treated as a single rental real estate enterprise or may be bifurcated into separate residential and commercial interests.
Once a taxpayer or RPE elects to treat each interest as a single rental real estate enterprise, it must continue that treatment for current and future property interests when utilizing the safe harbor. A taxpayer or RPE that elects to treat similar properties as a combined rental real estate enterprise may elect to treat them as separate rental real estate enterprises under the safe harbor in a future year.
The safe harbor
For a rental real estate enterprise to qualify under the safe harbor, four requirements must be met:
1. Separate books and records must be maintained to reflect income and expenses for each rental real estate enterprise.
2. For rental real estate enterprises that have been in existence less than four years, 250 or more hours of rental services must be performed per year with respect to the rental real estate enterprise. For rental real estate enterprises that have been in existence for at least four years, in any three of the five consecutive tax years that end with the current tax year, 250 or more hours of rental services must be performed.
3. For tax years beginning on or after Jan. 1, 2020, the taxpayer must maintain contemporaneous records, including time reports, logs or similar documents, regarding:
- Hours of all services performed;
- Description of all services performed;
- Dates on which such services were performed; and,
- Who performed the services.
For earlier tax years, the taxpayer still bears the burden of showing that the hours requirements have been met.
4. The taxpayer or RPE must attach a statement to a timely filed original tax return (or an amended return for the 2018 tax year only) for each tax year in which the taxpayer or RPE relies on the safe harbor.
The taxpayer or RPE must choose each year to use or not use the safe harbor.
Qualifying outside the safe harbor
Rev. Proc. 2019-38 reminds taxpayers that they may still qualify their rental real estate activities for the qualified business income deduction if they can meet the definition of a qualifying trade or business under Code Sec. 199A. This requires meeting the definition of a trade or business under Code Sec. 162 other than the trade or business of performing services as an employee. Rental or licensing of tangible or intangible property (rental activity) that does not rise to the level of a Code Sec. 162 trade or business may nevertheless qualify if the property is rented or licensed to a trade or business conducted by an individual or RPE which is commonly controlled.
Rental services that qualify for meeting the hours requirements include, but are not limited to:
- Advertising to rent or lease the real estate;
- Negotiating and executing leases;
- Verifying information contained in prospective tenant applications;
- Collection of rent;
- Daily operation, maintenance and repair of the property, including the purchase of materials and supplies;
- Management of the real estate; and,
- Supervision of employees and independent contractors.
Rental services that do not qualify include:
- Financial or investment management activities, such as financing;
- Studying and reviewing financial statements or reports;
- Improving the property under Regulation Sec. 1.263(a)-3(d); or,
- Hours spent traveling to and from the real estate.
Triple net leases
While triple net leases still do not qualify for the safe harbor, the definition of a triple net lease has been revised from Notice 2019-07. Rev. Proc. 2019-38 defines a triple net lease as a lease agreement that requires the tenant or lessee to pay taxes, fees and insurance, and to pay for maintenance activities for a property in addition to rent and utilities. In the notice, the term “to be responsible for” had been used instead of “to pay for.”
Rev. Proc. 2019-38 applies to tax years ending after Dec. 31, 2017. Alternatively, taxpayers and RPEs may rely on Notice 2019-07 for the 2018 tax year.
Rev. Proc. 2019-38 should permit many taxpayers engaged in rental real estate activities to qualify for the qualified business income deduction.