Nothing stays the same in the tax world. That’s especially true with your brand-new 20 percent Section 199A tax deduction.
In January, an IRS Notice gave us a Section 199A safe-harbor option for rental properties, possibly making it easier for us to qualify for this new tax deduction. Now, the IRS has made a number of changes to its original notice and finalized the safe harbor in a Revenue Procedure. We note the changes below.
Big Picture on Rentals
Your rental activities qualify for the Section 199A deduction in one of three ways:
- They are a tax code Section 162 trade or business.
- You rent them to a commonly controlled tax code Section 162 trade or business.
- They meet the Rev. Proc. 2019-38 safe harbor requirements.
Under the safe harbor, and solely for Section 199A purposes, the IRS will treat your rental real estate enterprise as a trade or business if you (or your pass-through entity) can satisfy the following three requirements:
- You maintain separate books and records that reflect the income and expenses of each rental real estate enterprise.
- You perform 250 or more hours of “rental services” during the tax year.
- You maintain 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.
Change #1. The “contemporaneous records” rule does not apply to tax years beginning before January 1, 2020—but don’t let this give you false hope. You still need proof.
Change #2. You can keep separate books and records for each property and later consolidate them to meet the record-keeping requirement.
Change #3. If the enterprise is in existence for at least four years, then you only need to meet the 250-hours test in any three of the five consecutive taxable years that end with the taxable year.
Change #4. The IRS clarified that use of the safe harbor is an annual determination.
Rental Real Estate Enterprise Requirements
To use the safe harbor, you arrange your rental activities into one or more rental real estate enterprises.
You have a choice. You can either
- treat each rental activity as its own enterprise, or
- put all commercial rental activities in one enterprise and all residential rental activities in one enterprise.
Change #5. You need to treat all the rental activities you place into a residential or commercial enterprise as a single trade or business for Section 199A purposes.
Change #6. You have two options for mixed-use properties. First, you can treat them as a single rental enterprise. Second, you can divide them into their component residential and commercial parts. You may not group multiple mixed-use rental activities into one mixed-use rental enterprise.
The following are not eligible for the safe harbor, and you can’t place them into an enterprise:
- Real estate you use as a residence under tax code Section 280A(d). Under this rule, your property is a personal residence if you use the property for personal purposes for a total number of days exceeding the greater of (a) 14 days or (b) 10 percent of the days you rented the property at fair market value.
- Real estate rented or leased under a triple net lease. For purposes of this safe harbor only, a triple net lease includes a lease agreement that requires the tenant or lessee to pay taxes, fees, and insurance, and to pay for maintenance activities for the property in addition to rent and utilities.
Change #7. For Section 199A purposes, real estate rented to a commonly controlled trade or business does not qualify for the safe harbor. You treat such a rental as being in the same business as the commonly controlled tenant.
Change #8. Real estate for which any portion is an out-of-favor specified service trade or business is not eligible for the safe harbor.
You or your pass-through entity must attach a statement to the tax return indicating that you are using the safe harbor and you satisfied the requirements set forth in Rev. Proc. 2019-38.
The statement has three required elements:
- A description (including the address and rental category) of all rental real estate properties you included in each rental real estate enterprise
- A description (including the address and rental category) of rental real estate properties acquired and disposed of during the taxable year
- A representation that the requirements of this revenue procedure have been satisfied
Change #9. You don’t have to sign the statement under penalty of perjury.
Sarah has four rental properties:
- Property A, a residential rental
- Property B, a commercial rental
- Property C, a commercial rental
- Property D, a mixed-use commercial and residential property
If Sarah wants to use the safe harbor, she can arrange her rentals in one of three configurations:
Configuration 1. Each property is its own enterprise. There are four enterprises:
- Property A
- Property B
- Property C
- Property D
Configuration 2. She combines the residential and commercial properties into their own enterprises and places the mixed-use property into its own enterprise. There are three enterprises:
- Property A
- Property B and Property C
- Property D
Configuration 3. She combines the residential and commercial properties into their own enterprises and bifurcates the mixed-use property. There are two enterprises:
- Property A and part of Property D
- Property B, Property C, and part of Property D
For all her rental activities to qualify for Section 199A under the safe harbor, Sarah will need to show
- 1,000 total hours of rental services in Configuration 1 (250 hours for each of the four enterprises);
- 750 total hours of rental services in Configuration 2 (250 hours for each of the three enterprises); and
- 500 total hours of rental services in Configuration 3 (250 hours for each of the two enterprises).
The good news with the safe harbor is that it gives you a guaranteed way to ensure that your rentals qualify for the Section 199A deduction.
The bad news is that you may not meet the requirements to qualify for the safe harbor.
If you would like to discuss how you might treat your rentals for the Section 199A tax deduction, please call us at (214) 214-3200.