IRS ISSUES FINAL GUIDANCE ON THE TREATMENT OF RENTAL PROPERTIES AND THE SECTION 199A DEDUCTION

NSTP199A

IRS ISSUES FINAL GUIDANCE ON THE TREATMENT OF RENTAL PROPERTIES AND THE SECTION 199A DEDUCTION:

On Friday, January 18th, the IRS released Notice 2019-07 which established a safe harbor under which a rental real estate enterprise would be considered a trade or business for eligibility of the 199A deduction.

To qualify for treatment as a trade or business under this safe harbor, the rental real estate enterprise must satisfy the requirements of the proposed revenue procedure.  If an enterprise fails to satisfy these requirements, the rental real estate enterprise may still be treated as a trade or business for purposes of section 199A if the enterprise otherwise meets the definition of trade or business in § 1.199A-1(b)(14). 

Following is the language from Notice 2019-07 which details the safe harbor provisions to be followed. Click here for the full text of the Notice.

The Treasury Department and the IRS are aware that whether a rental real estate enterprise is a trade or business for purposes of section 199A is the subject of uncertainty for some taxpayers.  To help mitigate this uncertainty, this proposed revenue procedure provides a safe harbor for treating a rental real estate enterprise as a trade or business solely for purposes of the section 199A deduction. (emphasis added by Editor)

SECTION 3.  RULES OF APPLICATION

.01 In general.  This safe harbor is available to taxpayers who seek to claim the deduction under section 199A with respect to a rental real estate enterprise. If the safe harbor requirements are met, the real estate enterprise will be treated as a trade or business as defined in section 199A(d) for purposes of applying the regulations under section 199A.  Relevant passthrough entities (RPEs) as defined in § 1.199A-1(b)(10) may also use this safe harbor in order to determine whether a rental real estate enterprise is a trade or business as defined in section 199A(d).  Failure to satisfy the requirements of this safe harbor does not preclude a taxpayer from otherwise establishing that a rental real estate enterprise is a trade or business for purposes of section 199A.

.02 Rental real estate enterprise.  Solely for purposes of this safe harbor, a rental real estate enterprise is defined as an interest in real property held for the production of rents and may consist of an interest in multiple properties.  The individual or RPE relying on this revenue procedure must hold the interest directly or through an entity disregarded as an entity separate from its owner under § 301.7701-3.  Taxpayers must either treat each property held for the production of rents as a separate enterprise or treat all similar properties held for the production of rents (with the exception of those described in paragraph .05 of this section) as a single enterprise.  Commercial and residential real estate may not be part of the same enterprise.  Taxpayers may not vary this treatment from year-to-year unless there has been a significant change in facts and circumstances.

.03 Safe harbor.  Solely for the purposes of section 199A, a rental real estate enterprise will be treated as a trade or business if the following requirements are satisfied during the taxable year with respect to the rental real estate enterprise:

  • Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise;
  • For taxable years beginning prior to January 1, 2023, 250 or more hours of rental services are performed (as described in this revenue procedure) per year with respect to the rental enterprise.  For taxable years beginning after December 31, 2022, in any three of the five consecutive taxable years that end with the taxable year (or in each year for an enterprise held for less than five years), 250 or more hours of rental services are performed (as described in this revenue procedure) per year with respect to the rental real estate enterprise; and
  • The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, regarding the following: (i) hours of all services performed; (ii) description of all services performed; (iii) dates on which such services were performed; and (iv) who performed the services.  Such records are to be made available for inspection at the request of the IRS.  The contemporaneous records requirement will not apply to taxable years beginning prior to January 1, 2019.

.04 Rental services.  Rental services for purpose of this revenue procedure include: (i) advertising to rent or lease the real estate; (ii) negotiating and executing leases; (iii) verifying information contained in prospective tenant applications; (iv) collection of rent; (v) daily operation, maintenance, and repair of the property; (vi) management of the real estate; (vii) purchase of materials; and (viii) supervision of employees and independent contractors.  Rental services may be performed by owners or by employees, agents, and/or independent contractors of the owners.  The term rental services does not include financial or investment management activities, such as arranging financing; procuring property; studying and reviewing financial statements or reports on operations; planning, managing, or constructing long-term capital improvements; or hours spent traveling to and from the real estate.

.05 Certain rental real estate arrangements excluded.  Real estate used by the taxpayer (including an owner or beneficiary of an RPE relying on this safe harbor) as a residence for any part of the year under section 280A is not eligible for this safe harbor.  Real estate rented or leased under a triple net lease is also not eligible for this safe harbor.  For purposes of this revenue procedure, a triple net lease includes a lease agreement that requires the tenant or lessee to pay taxes, fees, and insurance, and to be responsible for maintenance activities for a property in addition to rent and utilities.  This includes a lease agreement that requires the tenant or lessee to pay a portion of the taxes, fees, and insurance, and to be responsible for maintenance activities allocable to the portion of the property rented by the tenant.

.06 Procedural requirements for application of safe harborA taxpayer or RPE must include a statement attached to the return on which it claims the section 199A deduction or passes through section 199A information that the requirements in Section 3.03 of this revenue procedure have been satisfied.  The statement must be signed by the taxpayer, or an authorized representative of an eligible taxpayer or RPE, which states: “Under penalties of perjury, I (we) declare that I (we) have examined the statement, and, to the best of my (our) knowledge and belief, the statement contains all the relevant facts relating to the revenue procedure, and such facts are true, correct, and complete.”  The individual or individuals who sign must have personal knowledge of the facts and circumstances related to the statement.  (emphasis added by Editor)

Conclusion from the Editor: there has been a great deal of uncertainty regarding the application of the Section 199A provision of the Tax Cuts and Jobs Act for rental real estate activities. This new guidance by the IRS, which provides a safe harbor for the application of the 199A deduction, should help with identifying those clients that will qualify.

Note that properties which were used at any time during the year as a personal residence would not qualify as well as those properties with a triple net lease.

The paperwork requirements for separate books and records as well as contemporaneous records of services provided in the operations and maintenance of the real estate activity will pose a challenge for many of our clients. The requirement for books and records seems to be in place for 2018. However, the requirement for contemporaneous record of activities related to the rental properties started January 1, 2019 which is needed to support the 250-hour rule.

And do not forget the requirement for the perjury statement (which in all likelihood will be incorporated into our software) which must accompany each tax return claiming the 199A deduction for rental real estate activities.

One suggestion has been to provide a checklist for those clients who file either a Schedule E with the Form 1040 or Form 8825 with the business returns. You should be able to perform a sort in your tax software to identity these clients and send out a mailing, in addition to the organizer, to prepare your clients for the new requirements.

CHECKLIST FOR OWNERS OF RENTAL PROPERTIES

The IRS has issued safe harbor guidelines for the owners of rental properties in order to qualify for the new 20% deduction (Section 199A). While your rental activities may be considered an eligible trade or business with appropriate substantiation, the IRS has provided the following requirements if you elect to use the safe harbor method of qualifying for the deduction.

  • Keep a separate set of books for your rental activities – record the income and expenses for each property separately. Financial statements should be available for each rental property with supporting documentation of the expenses incurred. Bank statements and credit card statements are not sufficient substantiation. All receipts/purchase orders/contracts should be retained either in a paper file or in a scanned document file.
  • Any rental property in which you have personally resided or with which you have a triple net lease will not qualify for the safe harbor and financial records must be maintained independently of other rental properties.
  • Keep a contemporaneous journal of rental activities – per the new tax regulations a minimum of 250 hours must be performed in respect to your rental properties. This includes such activities as:
  • 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;
  • management of the real estate (which would include the time spent meeting the contemporaneous journal and bookkeeping requirements);
  • purchase of materials; and
  • supervision of employees and independent contractors

Note that traveling to/from your rental properties is not included in calculating the 250 hours per year of rental activity or activities related to properties in which you resided or have a triple net lease.

  • These requirements are solely for the purpose of qualifying for the Section 199A deduction safe harbor and do not constitute a change in the reporting of rental income and expenses. Ordinary and reasonable expenses in the operations of the rental property still qualify which does include the costs of travel to the rental properties.
  • The following list of expenses appears on the Schedule E/Form 8825 which are still allowable deductions:
    • Advertising
    • Auto and travel
    • Cleaning and maintenance
    • Commissions
    • Insurance
    • Legal and other professional fees
    • Management fees
    • Mortgage interest
    • Other interest
    • Repairs
    • Supplies
    • Taxes
    • Utilities
    • Depreciation or depletion expense
    • Other – which can include such items as:
      • HOA fees
      • Pest control
      • Security costs
      • Bank fees
      • Eviction expenses

Please contact the office if you have any questions regarding these issues or the recordkeeping requirements. The contemporaneous recordkeeping of the time you have spent in your rental activities is effective as of January 1, 2019. It is imperative that you reconstruct the records from the beginning of the year and maintain a log going forward of the time spent on your rental activities.