On Tuesday, September 24, 2019, the Treasury Department (“Treasury”) and the Internal Revenue Service (the “IRS”) released Revenue Procedure 2019-38 (“Rev. Proc. 2019-38”) that provides a safe harbor under which a rental real estate enterprise will be treated as a trade or business for purposes of section 199A of the Internal Revenue Code (the “Code”). Rev. Proc. 2019-38 finalized, with certain modifications, a proposed version of a revenue procedure containing such a safe harbor in Notice 2019-07, 2019-09 IRB 740. The safe harbor in Rev. Proc. 2019-38 (and previously in Notice 2019-07) was created out of Treasury and the IRS’s awareness of the uncertainty that certain taxpayers had regarding whether an interest in rental real estate rises to the level of a trade or business for purposes of section 199A, which stems from the Section 199A treasury regulations generally adopting the facts and circumstances trade or business test under section 162.
Section 199A was enacted as part of the Tax Cut and Jobs Act of 2017 (the “TCJA”) to provide a deduction to non-corporate taxpayers of up to 20 percent of the taxpayer’s qualified business income from each of the taxpayer’s qualified trades or businesses, including those operated through a partnership, S corporation, or sole proprietorship, as well as a deduction of up to 20 percent of aggregate real estate investment trust dividends and qualified publicly traded partnership income. Under Section 199A, a qualified trade or business is defined as any trade or business other than a specified service trade or business (SSTB) or a trade or business of performing services as an employee. For purposes of section 199A, a trade or business is defined as a section 162 trade or business, other than the trade or business of performing services as an employee. The treasury regulations under section 199A provide that rental or licensing of tangible or intangible property (rental activity) that does not rise to the level of section 162 trade or business is nevertheless treated as a trade or business for purposes of section 199A, if the property is rented or licensed to a trade or business conducted by the individual or a relevant passthrough entity (RPE) which is commonly controlled.
Revenue Procedure 2019-38
Given the uncertainty some taxpayers had as to whether a rental real estate enterprise is a trade or business for purposes of section 199A, the Treasury and IRS created the following safe harbor within Rev. Proc. 2019-38. The safe harbor is available to taxpayers and RPEs who seek to claim a deduction under section 199A with respect to a rental real estate enterprise. Each rental real estate enterprise that satisfies the requirements of the safe harbor will be treated as a single trade or business for purposes of the section 199A, and the regulations thereunder, including the aggregation rules. In order to rely upon the safe harbor, taxpayers and RPEs must satisfy all of the requirements of Rev. Proc. 2019-38, but failure to satisfy the safe harbor does not preclude an interest in rental real estate from being treated as a trade or business for purposes of section 199A. The determination to use the safe harbor must be made annually.
Rental Real Estate Enterprise
A rental real estate enterprise (“RREE”) is defined, solely for purposes of the safe harbor, as an interest in real property held for the production of rents and may consist of an interest in a single property or interests in multiple properties. The taxpayer or RPE must hold each interest directly or through a disregarded entity. With the exception of excluded interests (discussed below), taxpayers and RPEs may either treat each interest in similar property (i.e., part of the same rental real estate category) as a separate RREE or all similar properties as a single RREE.
The two types of rental real estate categories for purposes of combining properties into a single RREE are residential and commercial. In other words, commercial can only be combined with other commercial, and residential with other residential. Further, once a taxpayer or RPE treats interest in similar properties as a single RREE under the safe harbor, they must continue to treat interests in all similar properties (including newly acquired properties) as a single RREE under the safe harbor. If the taxpayer or RPE initially treats its interest in each residential or commercial property as a separate RREE, they may choose to combine them into a single RREE in a future year. An interest in mixed-use property (i.e., single building with both residential and commercial units) may be treated as a single RREE or may be bifurcated into separate residential and commercial interests. If an interest in mixed-use property is treated as a single RREE, it may not be treated as part of the same enterprise as other residential, commercial, or mixed-use property.
Solely for purposes of section 199A, each RREE will be treated as a single trade or business if the following requirements are satisfied during the taxable year with respect to the RREE:
(A) Books and Records. Separate books and records must be maintained to reflect income and expenses for each RREE. If a RREE contains more than one property, this requirement may be satisfied if income and expense information statements for each property are maintained and then consolidated.
(B) Hour Requirement. For RREEs that have been in existence less than four years, 250 or more hours of rental services are performed (as described below) per year with respect to the RREE, and for RREEs that have been in existence for at least four years, in any three of the five consecutive taxable years that end with the current taxable year, 250 or more hours of rental services are performed.
(C) Contemporaneous Records. The taxpayer or RPE maintains contemporaneous records, including time reports, logs, or similar documentation, regarding the following: (i) hours and description of all services performed; (ii) dates on which such services were performed, and (iii) who performed the services. If services are performed by employees or independent contractors, the taxpayer may provide a description of the rental services performed by such employee or independent contractor, including the amount of time spent performing such services, and time, wage, or payment records for such employee or independent contractor. Such records are to be made available for inspection upon request by the IRS.
(D) Attach Statement to Return. The taxpayer or RPE must attach a statement to a timely filed original return (or an amended return for 2018) for each taxable year in which the taxpayer or RPE relies on the safe harbor. If there is more than one RREE, a single statement may be submitted but the statement must list the required information separately for each RREE. The statement must include the following: (1) A description (including the address and rental category) of all rental real estate properties included in each RREE; (2) a description (including the address and rental category) of rental real estate properties acquired and disposed of during the taxable year; and (3) a representation that the requirements of Rev. Proc. 2019-38 have been satisfied.
Rev. Proc. 2019-38 provides a non-exhaustive list of what constitutes rental services, which includes: (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 rents; (v) daily operation, maintenance, and repair of the property, including the purchase of materials and supplies; (vi) management of the real estate; and (vii) supervision of employees and independent contractors. These services can be performed by owners (including owners of an RPE), or by employees, agents, and/or independent contractors of the owners, and still count towards the safe harbor hour requirement. However, rental services does not include financial or investment management activities (e.g., arranging financing), procuring property, reviewing financial statements or reports on operations, property improvements that require capitalization under Section 263A, or hours spent travelling to and from the subject real estate.
The following types of property may not be included in a RREE, and therefore not eligible for the safe harbor:
(A) Real estate used by the taxpayer as a residence under section 280A(d), including an owner or beneficiary of an RPE.
(B) Real estate rented or leased under a triple net lease. For purposes of Rev. Proc. 2019-38, 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 a property in addition to rent and utilities.
(C) Real estate rented to a trade or business conducted by a taxpayer or RPE which is commonly controlled under the aggregation rules of section 199A.
(D) The entire rental real estate interest if any portion of the interest is treated as an SSTB under the section 199A treasury regulations.
Rev. Proc. 2019-38 applies to taxable years beginning in 2018, but taxpayers and RPEs may rely on the safe harbor set forth in Notice 2019-07 for the 2018 taxable year. The contemporaneous records requirement will not apply to taxable years prior to 2020, but taxpayers should be mindful that they bear the burden of showing the right to any claimed deductions in all taxable years.
Treasury and the IRS specifically requested comments concerning: (i) Whether the proposed collection of information is necessary for the proper performance of the duties of the IRS, including whether the information will have practical utility; (ii) The accuracy of the estimated burden associated with the proposed collection of information (including underlying assumptions and methodology); (iii) How the quality, utility, and clarity of the information to be collected may be enhanced; (iv) How the burden of complying with the proposed collection of information may be minimized, including through the application of automated collection techniques or other forms of information technology; and (v) Estimates of capital or start-up costs and costs of operation, maintenance, and purchases of services to provide information.
As compared to Notice 2019-07, Rev. Proc. 2019-38 increased the procedural burdens that taxpayers and RPEs must undertake to satisfy the RREE safe harbor. One such burden includes the recording and documentation requirements with respect to services performed by employees and independent contractors. Another being the additional information required on the statement that must be attached to a timely filed original tax return for each taxable year in which the taxpayer or RPE relies on the safe harbor (albeit they did remove the requirement that the statement be signed under penalties of perjury).
Rev. Proc. 2019-38 did clarify some of the rules regarding treating similar properties as either separate RREE or as a single RREE, and made clear that once combined into a single RREE, all similar properties (including newly acquired properties) must remain combined when relying on the safe harbor. However, they allowed for separate RREEs to be combined into a single RREE in later years. Rev. Proc. 2019-38 also dealt with the categorization (and definition) of mixed-use properties, and allowing them their own segregated category if not bifurcated between residential and commercial.
Rev. Proc. 2019-38 also expanded what constituted excluded property interests to include real estate rented to a commonly controlled trade or business of the taxpayer or RPE, and the entire rental real estate interest if any portion of the interest is treated as an SSTB under treasury regulation 1.199A-5(c)(2). Lastly, despite hopes that the restriction on triple net leases would be loosened, the exclusion of real estate rented or leased under a triple net lease from the safe harbor remains (with minor clarifications).
Fortunately, for 2018 taxpayers and RPEs may rely on the less expansive safe harbor in Notice 2019-07, but going forward they will have to fit within the confines of the safe harbor provided under Rev. Proc. 2019-38.