The 20% deduction for pass-through income provided by Internal Revenue Code Section 199A applies only to income from a “trade or business.” To be engaged in a trade or business for federal income tax purposes, a taxpayer must be involved in an activity that is considerable, continuous, and regular, and the taxpayer must have a profit motive. There is not a bright-line test to determine whether an activity rises to the level of a trade or business under federal income tax law, and unfortunately for landlords seeking a 199A deduction, not every activity of leasing real property rises to the level of a trade or business.
On January 15, 2019, Final Regulations under Code Section 199A were issued, which acknowledged the uncertainty and difficulty that landlords (and their tax professionals) face in determining whether their rental real estate activities constitute a trade or business and, thus, whether a 199A deduction is available. Accordingly, also on January 15, a proposed revenue procedure was released which provides for a safe harbor under which a rental real estate activity may be treated as a trade or business solely for purposes of the 199A deduction.
The safe harbor contains three requirements. First, separate books and records must be maintained to reflect the income and expenses for each rental real estate enterprise. Second, at least 250 hours of rental services must be performed each year with respect to each rental real estate enterprise. The safe harbor provides a list of rental services that qualify for this requirement. Third, contemporaneous records must be kept regarding the hours of all services performed, description of all services performed, who performed the services, and when the services were performed.
The safe harbor, however, does not apply to a triple net lease, which includes a lease agreement that requires the tenant to pay taxes, fees, and insurance, and to be responsible for maintenance activities for a property, in addition to rent and utilities. The safe harbor defines a triple net lease to include an arrangement where the tenant pays a portion of the taxes, fees, and insurance and is responsible for maintenance activities allocable to the portion of the property rented by the tenant.
Failure to satisfy the safe harbor does not preclude a landlord from otherwise establishing that a rental real estate activity rises to the level of a trade or business under the first paragraph above for purposes of the 199A deduction, but such a task could be difficult, especially for a triple net lease.
So, what steps should landlords take now to secure a 199A deduction?
Landlords under non-triple net lease arrangements should determine if they can satisfy the 250 hour requirement of rental services and, if so, begin maintaining contemporaneous records.
Landlords under non-triple net lease arrangements that cannot satisfy the 250 hour requirement of rental services should examine if they can nevertheless take the position that their rental activities rise to the level of a trade or business under the factors described above.
Landlords under triple net lease arrangements should examine if they can nevertheless take the position that their rental activities rise to the level of a trade business under the factors described above, which may be very difficult. If such a position cannot be taken, they should consider modifying their lease arrangements so they can take such position.
If you have any questions, please contact Douglas T. Coats at 410-576-4002 or firstname.lastname@example.org.