Will rental real estate entities qualify for the 20 percent Section 199A pass-through deduction? This question has been on the mind of business owners and tax professionals since tax reform created this brand new section of tax code.
In previously proposed regulations, the IRS ironed out most of the eligibility and application details around Section 199A, but it was not until mid-January that final regulations were issued along with a proposed Revenue Procedure that provides relief and clarification to some, but not all, rental activities. Section 199A allows owners of qualified businesses to deduct up to 20 percent of qualified business income on their personal income tax return.
There are many caveats and thresholds to unpack around this new deduction so be sure to confer with your RKL advisor to determine the exact impact 199A may have on your business. Today, let’s focus on 199A’s impact in the hotly anticipated area of rental real estate enterprise.
199A safe harbor rules for rental real estate enterprise
In Revenue Procedure 2019-7, the IRS unveiled a safe harbor for rental real estate enterprises, which means that enterprises meeting the below rules will qualify for the 20 percent deduction as a Section 162 trade or business. To achieve safe harbor status, a rental real estate enterprise must:
- Maintain separate books and records of income and expenses for each rental real estate enterprise.
- Perform 250 or more hours of rental services between tax years 2018 and 2022. After 2022, this requirement will change to 250 or more hours of rental service in any three of the past five taxable years. This requirement applies to owners, employees or independent contractors and includes the following services:
- 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
- Purchase of materials, and
- Supervision of employees and independent contractors
Important note: Travel to and from the real estate may not be counted as part of the rental service hours.
- Maintain contemporaneous records of the following items (not applicable for taxable years beginning prior to January 1, 2019):
- Hours of all services performed
- Description of all services performed
- Dates on which such services were performed
- Who performed the services
Triple net leases ineligible for safe harbor
Another key aspect of the IRS guidance is that real estate rented under a triple net lease is not eligible for safe harbor. This is a clear indication that rental real estate enterprises that rent or lease solely on triple net leases will not be permitted by the IRS to take the 199A deduction in most circumstances. For the purposes of this guidance, the IRS considers a triple net lease any lease agreement that requires the tenant or lessee to pay the taxes, fees and insurance and also holds them responsible for rent, utilities and maintenance activities.
Rental to related qualified business under 199A
If a rental real estate enterprise rents real estate to a related business that qualifies for the 199A deduction, the rental real estate enterprise also qualifies for the 199A deduction. This means that if the rental real estate enterprise rents property to a business and the two entities have at least 50% common ownership, the rental real estate enterprise is automatically a trade or business, which allows it to take the 199A deduction.
Example: Partnership AA owns an office building that it rents to partnership AB, a computer repair company. Individual A owns 60 percent of each partnership AA and AB. Because AA is renting the real estate property to AB, which is commonly controlled, partnership AA is eligible for the 199A pass-through deduction.
While this long-awaited IRS guidance introduces the safe harbor test, it is not the end-all be-all. Real estate rental enterprises that do not fulfill all the rules may still have other business circumstances that restore eligibility for the 199A deduction.
The RKL tax team is closely tracking the implementation of many tax reform provisions, so contact your advisor to discuss your specific business scenario. Keep up with our tax reform thought leadership in our dedicated resource center or register for our e-news to stay up-to-date.
