On September 24, 2019, the Treasury Department and the Internal Revenue Service issued Revenue Procedure 2019-38 (the “Procedure”), which addresses a dilemma faced by certain owners of rental real estate. The issue exists because Internal Revenue Code (“Code”) Section 199A, which provides a deduction to non-corporate taxpayers of up to 20 percent of certain pass-through income, applies only to activities that rise to the level of a “trade or business.” The regulations under Code Section 199A define a “trade or business” with reference to Code Section 162, which generally means an activity rises to the level of a trade or business only when a taxpayer engages in an activity with a profit motive on a regular, continuous and substantial basis.
The problem is that not every activity of owning rental real estate with a profit motive rises to the level of a trade or business under Code Section 162; therefore, it may be uncertain as to whether such an activity would qualify for a Code Section 199A deduction. Adding to the problem, Code Section 199A imposes penalties on those taxpayers who improperly claim a Code Section 199A deduction. In acknowledgment of this uncertainty, the Procedure provides a safe harbor for treating a rental real estate enterprise as a trade or business for purposes of Code Section 199A.
To qualify under the safe harbor: (i) a taxpayer must maintain separate books and records reflecting income and expenses for each real estate enterprise, (ii) for rental real estate enterprises in existence less than four years, at least 250 hours of rental services must be performed each year with respect to such enterprise, (iii) for rental real estate enterprises in existence for at least four years, in any three of the last five consecutive years, at least 250 hours of rental services must be performed each year with respect to such enterprise, (iv) contemporaneous records must be maintained to document the number of hours of rental services, a description of such services and who performed such services, and (v) the taxpayer must attach a statement to the tax return for each year in which the taxpayer relies on the safe harbor.
The Procedure notes that the failure to satisfy the requirements of the safe harbor does not preclude a taxpayer from otherwise establishing that an interest in rental real estate rises to the level of a trade or business for purposes of Code Section 199A.
Triple net lease arrangements, unfortunately, are not eligible for the safe harbor. The Procedure defines a triple net lease to include a lease arrangement 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.
The Procedure generally applies to taxable years ending after December 31, 2017.