Section 199A Rental Income Safe Harbor
Posted January 19, 2019
Section 199A offers a 20% deduction for small business owners, but are rental properties considered a trade or business? The answer is Yes on Section 199A rental income but it took us some time to get here. In August 2018, the IRS and the Joint Committee on Taxation released Proposed Regulations 1.199A to offer some additional insight to Section 199A but nothing was clarified or confirmed about rental income.
The Treasury Department and the IRS held a public hearing on the proposed regulations on October 16, 2018 and they received 335 comments which can be reviewed in Treasury Decision 107892-18. Concurrently with final Section 199A regulations the IRS released Notice 2019-7 titled Section 199A Trade or Business Safe Harbor: Rental Real Estate.
Ok, now we are cooking! But let’s first bore you with the law; you need to walk before you can run.
Section 199A Trade or Business Definition
The term trade or business generally includes any activity carried on for the production of income from selling goods or performing services.
Here is another blurb from the IRS website-
A trade or business is generally an activity carried on for a livelihood or in good faith to make a profit. The facts and circumstances of each case determine whether or not an activity is a trade or business. The regularity of activities and transactions and the production of income are important elements. You do not need to actually make a profit to be in a trade or business as long as you have a profit motive. You do need, however, to make ongoing efforts to further the interests of your business.
All that seems fairly straightforward. Also, in Commissioner v. Groetzinger, 480 U.S. 23 (107 S.Ct. 980, 94 L.Ed.2d 25), the United States Supreme Court in 1987 held that for an activity to meet the definition of a trade or business it must be engaged to a) earn a profit and b) with some regularity and continuity. This is also most rental property owners, even if it is just one house. Don’t read too much into the “earn a profit.” This does not mean it must earn a profit… but your intentions for conducting the activity is to earn a profit (see the last sentence of the IRS blurb above).
Comments received by the Treasury Department and the IRS revealed that taxpayers and practitioners wanted a bright-line test, a factor-based test or a safe harbor definition for trade or business. In relying on Higgins v. Commissioner, 312 U.S. 212 (1941), where the U.S. Supreme Court specifically stated that defining a trade or business is facts and circumstances determination, the Treasury Department and the IRS declined to define trade or business more directly in the Section 199A final regulations.
Here is the blurb from the proposed regulations 1.199A which by and large became final regulations (this is a bit nauseating… sorry)-
Proposed § 1.199A–1(b) also defines trade or business for purposes of section 199A and proposed §§ 1.199A–1 through 1.199A–6. Neither the statutory text of section 199A nor the legislative history provides a definition of trade or business for purposes of section 199A. Multiple commenters stated that section 162 is the most appropriate definition for purposes of section 199A. Although the term trade or business is defined in more than one provision of the Code, the Department of the Treasury (Treasury Department) and the IRS agree with commenters that for purposes of section 199A, section 162(a) provides the most appropriate definition of a trade or business. This is based on the fact that the definition of trade or business under section 162 is derived from a large body of existing case law and administrative guidance interpreting the meaning of trade or business in the context of a broad range of industries. Thus, the definition of a trade or business under section 162 provides for administrable rules that are appropriate for the purposes of section 199A and which taxpayers have experience applying and therefore defining trade or business as a section 162 trade or business will reduce compliance costs, burden, and administrative complexity
Here is another blurb from IRS Notice 2019-7 that helps to summarize Section 199A definition of trade or business-
Section 199A(d) defines a qualified trade or business 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. Section 1.199A-1(b)(14) defines trade or business, in relevant part, as a trade or business under section 162 other than the trade or business of performing services as an employee. Sections 1.199A-5(b) and 1.199A-5(d) define an SSTB and the trade or business of performing services as an employee, respectively.
Great… what the heck does Section 162 read? Well, we have that covered too-
(a) In general. There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including-
(1) a reasonable allowance for salaries or other compensation for personal services actually rendered;
(2) traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or business; and
(3) rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity.
To summarize, the definition of a trade or business is a bunch of theoretic stuff built on vague statutory and case law. As such, the Treasury Department and the IRS with IRS Notice 2019-7 did create a Section 199A rental income safe harbor for the purposes of defining a trade or business. To very clear, the preamble of IRS Notice 2019-7 reads that your rental property may still qualify for the Section 199A deduction although it does not fit into the Section 199A rental real estate safe harbor rules. Let’s review those…
Section 199A Rental Property Safe Harbor
The majority of the 335 comments received by the IRS focused on rental income from real estate activities (shocker!). According to IRS Notice 2019-7, if the safe harbor provisions are met, a rental real estate enterprise will be treated as a trade or business and as such will enjoy the Section 199A deduction. The notice reads in part, “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.”
Two caveats; first, taxpayers must treat each property as a separate enterprise or group them together, your choice. Second, residential and commercial properties must be considered separate enterprises. Why is the enterprise stuff such a big deal? It factors into the record keeping provision of the Section 199A safe harbor rules. Read on!
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:
(A) Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise;
(B) 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
(C) 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.
The notice continues and beautifully defines rental services (to satisfy paragraph C above)-
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.
The Section 199A rental property safe harbor solves some problems for sure and it seems straightforward; keep books on the rental property, spend 250 hours performing rental services, and maintain records proving all this stuff.
Frankly, we see the 250 hour requirement being a bit challenging since that is about 5 hours per week, and if you have a singular rental property it is doubtful that over 20 hours is being spent per month managing it. Please recall that you must keep contemporaneous records (which means record keeping in real time) of your rental services to support the hours requirement (Yes, in January 2023 there is some relief on this).
So, what if we cannot meet the Section 199A safe harbor provisions for rental income? You can still demonstrate that your rental property meets the definition of a trade or business under Section 162. Think of other safe harbors- we have a home office safe harbor to reduce record keeping of actual expenses. We have a mileage reimbursement which is like a safe harbor; again to reduce the record keeping. We have a per diem reimbursement which again is like a safe harbor based on assumptions.
All of these safe harbors have two things in common; first, they are designed to simplify the support of a tax deduction. Second, taxpayers have an alternative system which might or might not be more difficult to support.
Here is our summary of the major issues recently updated by the final regulations, rental property safe harbor (Notice 2019-7) and how all this crud affects S corporations-
Jason Watson is the Managing Partner of the Watson CPA Group, a business consultation and tax preparation firm, and is the author of Taxpayer’s Comprehensive Guide on LLC’s and S Corps which is available online.