If your rental real estate business could use a boost in net profits, consider the possible advantages of tax planning under new Section 199A of the Internal Revenue Code. Section 199A allows a deduction of up to 20% of a taxpayer's qualified business income from pass-through entities, such as limited liability companies, partnerships, and S corporations.
Since passage of Section 199A, real estate investors were left with little guidance as to how or whether a rental real estate enterprise could qualify for the Section 199A deduction in light of the threshold requirement that the enterprise constitute an "active trade or business" under Section 162 of the Code. For many types of real estate projects, the active trade or business requirement poses little problem because of the considerable activity necessary to operate the property (e.g., large, multi-tenant residential rental properties). However, other types of real estate investments, such as single tenant commercial projects, may have difficulty meeting the requirement given the tendency to place responsibility for repair and maintenance on commercial tenants.
In recently issued Revenue Procedure 2019-38, the IRS provided some clarity by way of a safe harbor allowing a rental real estate enterprise to qualify for the Section 199A deduction. The Revenue Procedure provides that a rental real estate enterprise will be considered a trade or business, and therefore eligible for the Section 199A deduction, if the taxpayer can meet the following requirements:
- At least 250 hours per taxable year are spent providing "rental services," which include advertising, collection of rent, negotiating leases, property management, and daily operation, maintenance, and repair of the property. Such rental services can be performed by owners, employees, agents, or independent contractors. Additionally, if the rental real estate enterprise has been in existence for more than four years, it can satisfy the safe harbor requirements by meeting the 250-hour rental services requirement in any three of the five consecutive years ending with the taxable year.
- Satisfaction of the 250-hour requirement must be documented with records tracking the hours of services performed, a description of services performed, the dates on which such services were performed, and the identity of the person performing the services.
Importantly, a taxpayer has the option to aggregate similar properties for purposes of this 250-hour per year requirement. For example, multiple residential rental properties can be aggregated, and multiple commercial rental properties can be aggregated, but residential rental property and commercial rental properties cannot be aggregated for purposes of satisfying the 250-hour per year requirement. Additionally, mixed-use properties cannot be aggregated with residential, commercial, or other mixed-use properties. Instead, if aggregation of a mixed-use property is needed to satisfy the 250-hour per year requirement, the taxpayer must elect to separate the commercial aspect and residential aspect of a mixed-use property for purposes of aggregation.
Unfortunately, the safe harbor cannot be satisfied if the real estate is rented under a triple net lease. This does not mean that owners of projects subject to triple net leases cannot qualify for the Section 199A deduction, but such owners will need to demonstrate a level of activity sufficient to constitute an active trade or business under Section 162 of the Code (which will be difficult for smaller projects or those with fewer tenants). Given the lack of guidance defining a triple net lease, most practitioners are opting for gross leases where satisfaction of the safe harbor is otherwise possible.
Of course, nothing involving the Internal Revenue Code is ever simple. Other rules, such as the Wage/Property Limitation, may limit or eliminate the Section 199A deduction for higher earning taxpayers. If a company believes it may be able to satisfy the safe harbor, it should conduct a more thorough analysis with assistance from its tax counsel or certified public accountant.