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.
IRS Notice 2019-7 also bans triple net (NNN) leases from the safe harbor. This makes sense in a roundabout way since a trade or business by definition is an activity that seeks to maximize revenue and minimize expenses. Triple net leases are not designed to minimize expenses since most expenses are passed along to the tenants; this is one of the largest complaints of tenants since the landlord does not have an incentive to save money. Toilet clogged? Let’s call the most expensive and least responsive plumber we can.
Section 199A Self-Rental Income
What about self-rental income? Good question. A common scenario would be a business owner who owns the building or warehouse as an individual, and leases it back to the business. Does this self-rental income qualify as qualified business income for the Section 199A deduction? We say Yes given there is no direct contradiction anywhere about this… and we have good logic (in our opinion of course). Here we go-
Recall that the preamble of IRS Notice 2019-7 reads that rental income may still qualify as a trade or business without meeting the thresholds of the safe harbor provisions. Our position is if you are charging market rent and you can support either the rental safe harbor or Section 162 definitions of a trade or business, then you may take the Section 199A deduction on self-rental income.
Consider this- if you owned a business, and you rented the building from some bloke you would be creating a possible Section 199A deduction for this person, and your business income would go down by the rent expense. Makes sense. Also, if you are the bloke and you have net rental income as a landlord, then you would have a possible Section 199A deduction. As such, you are not creating a situation with a self-rental that otherwise would not exist without the self-rental relationship.
Some would argue that a specified service trade or business (SSTB) could shift income that would normally not qualify for a Section 199A deduction into self-rental income that may qualify. This was part of the “crack and pack” strategy of splitting up an entity into SSTB and non-SSTB operations, thus being able to qualify for a Section 199A deduction on the non-SSTB operation (provided you hit those income limits that required the secondary SSTB test with the sliding scale of phaseout).
The proposed regulations 1.199A added provisions preventing this. So, if an accountant owns the firm and the building in separate entities, the self-rental income becomes “tainted” and is considered SSTB income. This is because both entities have greater than 50% common control. And No, you cannot have your spouse own the building and you own the SSTB business; attribution rules get in the way and state that you both own everything. Again, common control. Here is a blurb right from the regulations-
Example. Law Firm is a partnership that provides legal services to clients, owns its own office building and employs its own administrative staff. Law Firm divides into three partnerships. Partnership 1 performs legal services to clients. Partnership 2 owns the office building and rents the entire building to Partnership 1. Partnership 3 employs the administrative staff and through a contract with Partnership 1 provides administrative services to Partnership 1 in exchange for fees. All three of the partnerships are owned by the same people (the original owners of Law Firm). Because there is 50% or more common ownership of each of the three partnerships, Partnership 2 provides substantially all of its property to Partnership 1, and Partnership 3 provides substantially all of its services to Partnership 1, Partnerships 1, 2, and 3 will be treated as one SSTB under paragraph (a)(6) of this section.
This is unfortunate in our opinion. This same law firm leases office space from an unrelated party; the law firm might not qualify for the Section 199A deduction because of SSTB income limitations but the landlord might. Provided the rent charged in a self-rental situation is market rent, why can’t the law firm also be a landlord? We want to say Yes, but the IRS says No. We believe this will be challenged in some fashion since it appears on its face to be discriminatory, and provided the self-rental is at market rates it appears to treat two rental operations differently depending on the relationship between landlord and tenant.
For non-specified service trade or business situations, the big takeaway is make sure this transaction has all the appearances of an arms-length transaction, fair dealings (versus self-serving), fair market pricing, etc. Caution: the self-rental consideration has not been challenged in a tax court; there is a lot of risk since your Section 199A deduction on a self-rental is predicated upon being able to demonstrate that it rises to the level of a trade or business.
Section 199A Rental Income Pitfalls
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. We believe this new rental safe harbor is bunk; the U.S. Supreme Court has already stated that rentals may be deemed a trade or business, and while the burden is on the taxpayer to demonstrate that it is, the threshold is qualitative rather than the quantitative rules of IRS Notice 2019-7.
Here are some other considerations-
- Make sure you are attempting to maximize profits by charging market rent and maintaining control on expenses.
- Vacation homes and VRBO / AirBNB situations where you personally use the property as well are probably not going to pass either the safe harbor or Section 162 as a trade or business. Let it go unless the property is a standalone and separate activity from your personal residence.
- The safe harbor is not a hurdle or threshold for all rental income to be eligible for the Section 199A deduction. It was deigned (and poorly so) to make it easier for taxpayers from a compliance perspective; “hey, meet these hurdles and we won’t demand a bunch of proof.” Really?! Contemporaneous records showing 250 hours is easier? Compare this safe harbor to home office, mileage or per diem, and you’ll see what we mean. You are still allowed to prove it is a trade or business under Section 162.
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.