Classifying Real Estate as Section 162 Trade or Business
One of the many complicated provisions of The Tax Cuts and Jobs Act is Section 199A, which permits certain individual taxpayers to deduct up to 20% of their qualified business income (“QBI”) coming from their ownership interests in qualified trades or businesses. Such a trade or business is commonly referred to as a “Section 162 trade or business.”
Please note that the Section 199A calculation is complex and contains various limitations depending on specific facts and circumstances. This article does not address the mechanics of the Section 199A calculation, but rather focuses on the ability of taxpayers to classify rental real estate as a Section 162 trade or business. Before the IRS released Notice 2019-07 on January 18, 2019, it wasn’t clear whether a rental real estate enterprise would be classified as a Section 162 trade or business. Notice 2019-07 establishes a safe harbor in an attempt to address this issue. It is important to note that there could be subsequent revisions to these safe harbor rules as the Notice contains a proposed Revenue Procedure, and the IRS is seeking commentary on the proposed language from practitioners.
Criteria for Rental Activity to be Considered Section 162 Trade or Business
If the rental activity meets all of the following criteria, then the activity will be considered a Section 162 trade or business for purposes of claiming the new Section 199A deduction:
- Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise. A rental real estate enterprise is defined as an interest in real property held to produce rents and may consist of an interest in multiple properties. Taxpayers can treat each rental real estate property as a stand-alone enterprise or group together similar properties and treat each group as an enterprise.
- For taxable years beginning before January 1, 2023, 250 or more hours of rental services must be performed 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 per year with respect to the rental real estate enterprise.
- Maintenance of contemporaneous records. The contemporaneous records requirement does not apply to taxable years beginning before January 1, 2019. Such records should include descriptions of services performed along with hours, dates, and who performed the services.
Rental Real Estate Safe Harbor
This safe harbor generally cannot be relied upon for any property leased via a triple net lease. A triple net lease is a lease whereby the tenant pays for all costs related to the asset being leased, including insurance, real estate taxes, and common area maintenance. The distinction being that such a leasing arrangement is more akin to investment rather than an operating business. Note, however, that the Section 199A final regulations state that a real estate rental activity will be considered a Section 162 trade or business if rented to a “commonly controlled” Section 162 trade or business (a so-called “self-rental”). Commonly controlled means that the rental activity and the Section 162 trade or business are 50 percent or more directly or indirectly owned by the same person or group of persons. The Section 162 trade or business cannot be a C-corporation.
Further, the safe harbor is not applicable if the number of days the taxpayer uses the residential rental property for personal purposes (used/rented for less than fair rental rates) exceeds the greater of 14 days or 10 percent of the number of fair market value days during the year.
Addressing the criteria above:
- The separate books and records criterion essentially means that to the extent possible, besides maintaining accounting records for each rental activity (or group of activities), commingling of personal and business transactions should be kept to a minimum. Considering maintaining business-only bank checking and credit card accounts rather than checking and credit card accounts used for both business and personal use.
- Rental services include the following:
- 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.
Rental services may be performed by owners (including relatives) or by agents, employees, or independent contractors. Accordingly, you should request hourly accounting from your vendors as well as maintaining records for your time.
Please note that rental services do 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 travel time.
- Beginning in 2019, the records must be maintained on a contemporaneous basis. Unlike charitable contributions, this doesn’t mean that transactions only need to be recorded by the due date of the tax return. This means that transactions should be recorded completely and accurately as they occur or shortly after that, not weeks or months later. Because you must keep track of not only financial transactions but time expended, you should maintain both accounting records and details of time incurred as well. We have a basic spreadsheet template that is available upon request.
- If you are using the safe harbor guidelines in connection with the claiming Section 199A deduction, you must attach a signed statement to your income tax return (the return claiming the Section 199A deduction) which states: “Under penalties of perjury, I (we) declare that I (we) have examined the statement, and, to the best of my (our) knowledge and belief, the statement contains all the relevant facts relating to the revenue procedure, and such facts are true, correct, and complete.”
It should also be noted that if a rental real estate activity fails to satisfy the safe harbor requirements, the activity may still be treated as a Section 162 trade or business (and thus qualify for the Section 199A deduction) if it otherwise meets the definition of a trade or business pursuant to Reg. Section 1.199A(b)(14).