September 30, 2019 Final IRC Section 199A safe harbor for rental real estate activities retains framework of proposed safe harbor, but differs in key respects In recently released Revenue Procedure 2019-38 (the revenue procedure), the IRS provides a safe harbor under which a "rental real estate enterprise" will be treated as a trade or business for purposes of the IRC Section 199A pass-through deduction. The revenue procedure's safe harbor attempts to mitigate uncertainty about whether an interest in rental real estate rises to the level of a trade or business for purposes of IRC Section 199A, which allows a deduction for certain income from a trade or business. The revenue procedure allows taxpayers and relevant pass-through entities (RPEs) to treat a rental real estate enterprise as a single trade or businesses solely for purposes of IRC Section 199A, if certain requirements are met. Revenue Procedure 2019-38 applies to tax years ending after December 31, 2017. The IRS previously published a proposed revenue procedure in Notice 2019-07, 2019-09 IRB 740 (the proposed revenue procedure), on which taxpayers may rely for the 2018 tax year (see Tax Alert 2019-0218) for a discussion of the proposed revenue procedure and IRC Section 199A generally). While Revenue Procedure 2019-38 retains the framework of the proposed revenue procedure, it differs in key respects. IRC Section 199A IRC Section 199A, added to the Code by the Tax Cuts and Jobs Act (the TCJA), generally allows non-corporate taxpayers to deduct the combined qualified business income (CQBI) amount. Subject to certain limitations and netting rules, the CQBI amount is the sum of (i) 20% of qualified business income (QBI) from each "qualified trade or business" (QTB) conducted by a partnership, S corporation, and/or sole proprietorship, (ii) 20% of qualified REIT dividends, and (iii) 20% of qualified publicly traded partnership income. Under the IRC Section 199A computational rules, taxpayers and RPEs must determine whether they are engaged in a trade or business and, if so, how many trades or businesses in which they are engaged. The final regulations under IRC Section 199A generally define the term trade or business by reference to IRC Section 162. The application of the IRC Section 162 standard to various real estate activities is unclear and the final regulations under IRC Section 199A declined to adopt any bright line rules regarding the treatment of rental real estate activity. Revenue Procedure 2019-38 As noted, the revenue procedure's safe harbor attempts to mitigate uncertainty about whether an interest in rental real estate rises to the level of a trade or business for purposes of IRC Section 199A. A rental real estate enterprise will be treated as a single trade or business for purposes of applying the regulations under IRC Section 199A, including the aggregation rules, if the taxpayer or RPE satisfies the safe harbor's requirements. To use the revenue procedure's safe harbor, a taxpayer must have one (or more) rental real estate enterprises and meet certain requirements. Furthermore, taxpayers may not use the revenue procedure for certain types of rental properties. Definition of "rental real estate enterprise" To use the revenue procedure's safe harbor, a taxpayer must first identify its rental real estate enterprise(s). A rental real estate enterprise is an interest in real property held for the production of rents. A rental real estate enterprise may consist of an interest in a single property or interests in multiple properties. Each interest must be held directly or through a disregarded entity. Insight: The revenue procedure, as opposed to the proposed revenue procedure, clarifies that an interest in a single property can constitute a rental real estate enterprise. While this is unlikely to surprise many, the clarification is welcome. Insight: The revenue procedure makes clear that a rental real estate enterprise may not consist of interests held through different regarded tax entities. Thus, taxpayers may not use the revenue procedure to "group" interests in rental properties held through different regarded tax entities. In certain circumstances, however, taxpayers may be able to use the aggregation rules in Treas. Reg. Section 1.199A-4 for similar ends. The factors in the revenue procedure and the Treas. Reg. Section 1.199A-4 are distinct and, in many common circumstances, taxpayers will be unable to utilize the aggregation rules. Special rules for similar properties Revenue Procedure 2019-38 does not allow a single rental real estate enterprise to consist of interests in properties that are not similar properties and requires all "similar properties" to be treated either as separate rental real estate enterprises or as a single rental real estate enterprise. For this purpose, properties are similar if they are part of the same rental real estate category: residential or commercial. Insight: Many taxpayers expressed concerns that the proposed revenue procedure prohibited taxpayers from treating commercial and residential properties as a single real estate enterprise. The revenue procedure contains the same prohibition (but, as discussed later, an interest in a single mixed-used property may be treated as a single real estate enterprise). Moreover, once multiple interests are treated as a single rental real estate enterprise under the safe harbor, they must continue to be treated as such if the taxpayer or RPE continues to rely on the safe harbor. If similar properties are treated as a single rental real estate enterprise, newly acquired similar properties must be added to the existing rental real estate enterprise. Insight: The requirement regarding similar properties functions as an "all-or-one" rule, as illustrated by the following example: Taxpayer (TP) has four residential properties (similar properties of one type) and three commercial properties (similar properties of another type). Under the safe harbor, TP appears to be allowed to make only the following groupings, resulting in different numbers of rental real estate enterprises: Option 1 — two rental real estate enterprises: All four residential properties are one rental real estate enterprise and all three commercial properties are one rental real estate enterprise. Option 2 — five rental real estate enterprises: Each of the four residential properties is a separate rental real estate enterprise and all three commercial properties are one rental real estate enterprise. Option 3 — four rental real estate enterprises: All four residential properties are one rental real estate enterprise and each of the three commercial properties is a separate rental real estate enterprise. Option 4 — seven rental real estate enterprises: Each of the four residential properties is a separate rental real estate enterprise and each of the three commercial properties is a separate rental real estate enterprise. TP may not group less than all (i.e., two or three) of the four residential properties. TP may not group less than all (i.e., two) of the three commercial properties. Moreover, if TP, for example, acquires another residential property in Option 1 or 3 and continued to rely on the revenue procedure's safe harbor, the newly acquired residential property must be treated as part of the existing residential rental real estate enterprise. Treatment of mixed-use property Revenue Procedure 2019-38 addresses the treatment of mixed-use property (defined for purposes of the revenue procedure as "a single building that combines residential and commercial units"). Insight: Many taxpayers expressed concerns that the proposed revenue procedure did not address mixed-used property. The fact that the revenue procedure addresses mixed-used property will be welcome by some. Revenue Procedure 2019-38 provides that an interest in a single mixed-used property may be (i) treated as a single rental real estate enterprise or (ii) bifurcated into separate residential and commercial interests. If an interest in a single mixed-used property is treated as a single rental real estate enterprise, it may not be combined with any other residential, commercial, or mixed-use property (no further grouping is allowed). Insight: The revenue procedure does not explicitly address whether an interest in single mixed-used property that is bifurcated into separate residential and commercial interests can or must be grouped with an existing residential or commercial rental real estate enterprise. Once a mixed-used property is bifurcated, it appears that the rules for similar properties, discussed previously, apply. Thus, it appears the commercial portion of a bifurcated mixed-used property could comprise a portion of a commercial rental real estate enterprise and a residential portion of a bifurcated mixed-used property could comprise a portion of a residential rental real estate enterprise. Certain rental real estate interests excluded Like the proposed revenue procedure, Revenue Procedure 2019-38 excludes property leased under a triple net lease from eligibility under the safe harbor. Insight: Many taxpayers hoped that triple net leased property would be safe-harbor eligible under the final revenue procedure. The revenue procedure, however, maintains the exclusion from the safe harbor. For purposes of the revenue procedure, "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." Insight: The revenue procedure further clarified the definition of triple net leased property as compared to the definition in the proposed revenue procedure. Under the proposed revenue procedure, a lease agreement must require the tenant to be responsible for maintenance activities to constitute a triple net lease. Under Revenue Procedure 2019-38, however, the lease agreement must merely require the tenant to pay for maintenance activities. This change appears consistent with the IRS's view that triple net lease arrangements may involve tenants paying common area maintenance charges. Insight: The definition of a triple net lease under the revenue procedure is non-exclusive, so it is unclear whether triple net lease characterization under other authorities will also be excluded from the rental real estate enterprise safe harbor. In addition, the following real estate arrangements may not be included in a rental real estate enterprise and are thus not eligible for the safe harbor: (1) real estate used by the taxpayer as a residence under IRC Section 280A(d); (2) real estate rented to a trade or business conducted by a taxpayer or an RPE that is commonly controlled under Treas. Reg. Section 1.199A-4(b)(1)(i); and (3) the entire rental real estate interest if any portion of the interest is treated as a specified service trade or business under Treas. Reg. Section 1.199A-5(c)(2). Requirements to qualify for the safe harbor The taxpayer must satisfy all the requirements set forth in the following chart to qualify for the safe harbor. The determination is made annually. Insight: As the requirements must be satisfied annually, the fact that a taxpayer had a rental real estate enterprise in a prior year is not determinative. Taxpayers using the safe harbor must re-analyze their facts every year.
Effects of qualifying under the safe harbor The revenue procedure treats each rental real estate enterprise satisfying the requirements of the safe harbor as a separate trade or business for purposes of applying IRC Section 199A, including the aggregation rules in Treas. Reg. Section 1.199A-4. Insight: The safe harbor's rule for similar properties, which may be viewed as a grouping rule, is more restrictive than Treas. Reg. Section 1.199A-4's aggregation rules, which do not require a taxpayer to group all eligible trades or businesses. Taxpayers may, however, use Treas. Reg. Section 1.199A-4's aggregation rules to group rental real estate enterprises. The policy rationale for this is not clear. The revenue procedure makes clear that a failure to satisfy the conditions of the safe harbor does not prohibit taxpayers from treating a rental real estate activity as a trade or business. Taxpayers and RPEs may still use the IRC Section 162 standard for such purposes. Insight: Case law and other guidance address the facts and circumstances relevant to determining if an activity is a trade or business under IRC Section 162. Furthermore, the Preamble to the IRC Section 199A final regulations provides a list of factors that it states might be relevant in determining whether a rental real estate activity is an IRC Section 162 trade or business.3 The guidance, however, may be viewed as providing insufficient clarity in many cases. Conclusion The issuance of the revenue procedure, intended to mitigate uncertainty regarding whether certain rental real estate activity rises to the level of a trade or business for purposes of IRC Section 199A, will assist some taxpayers with rental real estate activities. However, key aspects of the revenue procedure - including the inability to combine residential and commercial rental real estate interests, the inability to combine less than all of a taxpayer's residential (or commercial) interests, and the inability to combine mixed-used properties - will likely motivate many taxpayers to use the IRC Section 162 standard instead. The retention of the 250-hour requirement will likely have the same effect. Taxpayers should be aware that they may use either the revenue procedure or the proposed revenue procedure for the 2018 tax year. Taxpayers choosing between the revenue procedure or the proposed revenue procedure for that tax year should note the differences previously highlighted, including the different definitions of a triple net lease and the treatment of mixed-used property in the revenue procedure. Moreover, taxpayers using the proposed revenue procedure for the 2018 tax year in a manner contradictory to Revenue Procedure 2019-38 may face uncertainties in future years. In all, taxpayers with rental real estate interests and their advisors should carefully consider the recently released revenue procedure when determining whether - and to what extent - they (or their owners) are eligible for the IRC Section 199A deduction. Such taxpayers should further weigh whether relying on the revenue procedure, as opposed to the IRC Section 162 standard, is beneficial based on their specific facts. ———————————————
——————————————— 1 Under the proposed revenue procedure, activities that qualify as rental services are: 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. 2 Under the proposed revenue procedure, 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 do not qualify as rental services. 3 The factors listed are: (i) the type of rented property (commercial real property versus residential property), (ii) the number of properties rented, (iii) the owner's or the owner's agents' day-to-day involvement, (iv) the types and significance of any ancillary services provided under the lease, and (v) the terms of the lease (for example, a net lease versus a traditional lease and a short-term lease versus a long-term lease). | |||||||||||||||||||||||||||||||||||||||||||||