The Rental Real Estate Safe Harbor for QBI Deductions and Its Questionable Benefits
On Sep. 24, 2019, the IRS finalized a safe harbor procedure that taxpayers may use to treat a rental real estate enterprise as a trade or business for purposes of the Section 199A Qualified Business Income (QBI) deduction. The final procedure eases certain conditions that appeared previously under a proposed procedure. Although the final procedure aims to resolve uncertainty concerning the trade or business determination for rental real estate enterprises, it retains relatively high eligibility criteria. Because the presence of these criteria would enable most taxpayers to make a trade or business determination under existing standards, many taxpayers may find that the safe harbor provides little in the way of additional clarity or comfort.
Trade or Business Determinations for the QBI Deduction
The tax reform law commonly known as the Tax Cuts and Jobs Act (TCJA) established the 20% QBI deduction. Individuals and trusts benefit from the QBI deduction only when they own an interest in an activity that rises to the level of a trade or business.
Whether a rental activity rises to this level is a question that has vexed taxpayers for over 80 years, where judicial interpretations of facts and circumstances continue to set the prevailing standards. The widespread application of the QBI deduction renewed taxpayer requests for IRS clarity on this important question concerning rental activities. The new safe harbor represents the IRS efforts to clarify the trade or business determination for rental activities, which are called rental real estate enterprises (RREE) in the safe harbor.
Eligibility Criteria for the RREE Safe Harbor
The final safe harbor procedure establishes the following criteria that a taxpayer’s RREE must meet to be treated as a trade or business for QBI deduction purposes:
Maintain Separate Books and Records for Each RREE.
The final safe harbor clarifies that consolidated income expense and information statements from separate properties will satisfy this requirement.
Perform 250 hours of Rental Services Annually for Each RREE.
The 250-hour requirement sets a relatively high standard, but the final safe harbor clarifies the requirement in key regards to make it somewhat easier to meet:
Who is Eligible to Provide Rental Services?
Owners, employees, agents, or independent contractors can perform rental services that count towards the 250-hour requirement.
What Constitutes a Rental Service?
A non-exclusive list of rental services include:
- Advertising for lease, negotiating and executing leases;
- Diligence procedures for prospective tenants;
- Collection of rents, daily operation or maintenance and repair (including purchases of materials and supplies);
- Management of the real estate; and
- Supervision of employees and independent contractors.
Rental services do not include:
- Travel to and from the real estate;
- Financial and investment activities (such as arranging financing);
- Procuring the property,
- Studying or analyzing financial statements or reports from operations; or
- Improving the property (as defined under Regulations section 1.263(a)-3(d)).
Are Pre-Existing RREEs Eligible?
A RREE in existence for at least 4 years need only meet the 250-hour requirement for any three of the five years that end with the tax year in question.
Maintain Contemporaneous Records to Substantiate the 250-hour Requirement.
This requirement may be impractical for some taxpayers, where contemporaneous recordkeeping can prove challenging for owners who tend personally to each RREE.
The contemporaneous recordkeeping requirement applies only to tax years beginning on or after Jan. 1, 2020.
What Types of Records Satisfy the RREE Requirement?
Records that will satisfy the requirement include time reporting logs and other documents, but in any case, they must indicate the amount of hours performed, a description of the services performed, the date when the services were performed, and a record of who performed the services.
It appears that a taxpayer could meet this requirement with an employee’s timesheet, a copy of their job description, and paystubs or other invoice/payment records.
If the taxpayer employs a property manager, then the contract between the taxpayer and the property manager, time records or estimates of time records for the property manager or its employees, and invoices/payment records appear to be sufficient records to meet this requirement.
Satisfy Information Disclosure Requirements
If a taxpayer elects the use of the RREE safe harbor, it must attached a statement to a timely filed original return for each year that the safe harbor is applied to a RREE. If the safe harbor is applied to more than one RREE, the information can be provided on a single statement but it must provide the necessary information for each RREE.
The information must indicate the following for each RREE:
- A description (including the address and rental category) of all rental real estate properties included in the RREE.
- A description (including the address and rental category) of all rental real estate properties acquired and disposed of during the tax year.
- A representation that all of the requirements of the safe harbor procedure have been satisfied.
Taxpayers are not required to separately sign the information disclosure statement, where the tax return signature itself is applied toward the disclosure statement.
Does One or More Rental Real Estate Properties Constitute a Single RREE?
The final safe harbor explicitly states that a single property can qualify as a trade or business under the safe harbor. The safe harbor also describes conditions whereby multiple properties constitute a single RREE. The safe harbor resolves certain taxpayers concerns in this regard, but the criteria of the safe harbor concerning the types of properties that may be “grouped” into a single RREE may not always align with a taxpayer’s economic business objectives for multiple rental properties.
The safe harbor prohibits grouping commercial properties with residential properties into a single RREE. The safe harbor also imposes an all-or-nothing rule on a taxpayer’s grouping decision. Moreover, a taxpayer that elects to group similar properties into a single RREE must include all of those similar properties into the RREE. Any subsequent acquisitions of similar properties must then be integrated into that group.
Under the safe harbor, an activity is a similar activity if it falls into the same residential or commercial rental category. For example, if a taxpayer owns three residential rental houses, the taxpayer must treat each property as a separate RREE, or alternatively the taxpayer must group all three into a single RREE. If the taxpayer acquired a fourth rental house in a subsequent year, the taxpayer must add the fourth property to the existing residential property group. In any case, the taxpayer cannot include a commercial office space in the residential group under these rules.
Modified rules apply if the taxpayer owns a mixed-used property (a single property that is used for both commercial and residential rental activities). The taxpayer has two options concerning mixed-use properties.
Under the first option, a taxpayer may treat the mixed-use property as a single RREE that cannot be grouped with any other rental activity, including another mixed-use property. Under the second option, the taxpayer may split the property into its separate commercial and residential components for purposes of the safe harbor.
Unfortunately, it is not clear that this bifurcation option requires or permits the taxpayer to group the separate residential and commercial components with other residential or commercial properties that are subject to grouping. Logically, it would appear that the components must be grouped with a respective residential or commercial property group.
Certain Properties Not Eligible for Safe Harbor Treatment
A negative that remains in the final safe harbor is that rental properties subject to “triple-net leases” remain ineligible for safe harbor treatment. A triple-net lease is defined to mean a “lease arrangement 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.”
Other properties that do not qualify for the safe harbor are properties that the taxpayer uses as a residence, the entire rental real estate activity if any portion of the activity is treated as a specified services trade or business, and any rental property that is rented to a commonly controlled trade or business. Common control exists for this purpose when the taxpayer and a related party owns 50% or more of both the rental property and the trade or business.
The choice to make the safe harbor election is not necessarily any easier than under the former proposed rules. Additionally, a taxpayer’s rental activity may still rise to the level of a trade or business for purposes of the QBI deduction under judicial standards, regardless of the safe harbor election. In fact, if a taxpayer meets the safe harbor election requirements, then it is a near certainty that the taxpayer would meet the judicial standards for a trade or business without needing to make the safe harbor election.
Accordingly, taxpayers may find that the safe harbor provides less in the way of added clarity than it does through “belt and suspenders” assurances about the trade or business determination. Taxpayers should discuss the pros and cons of making the election with their local CBIZ tax professional.
Tax Reform and Your business: Landlords and Rental Trade or Business Determinations