The IRS issued Rev. Proc. 2019-38
to provide a safe harbor under which a rental real estate enterprise will be treated as a trade or business solely for purposes of the qualified business income (QBI) deduction under Section 199A.
Generally, the QBI deduction is available with respect to an eligible taxpayer’s qualified trade or business. A level of uncertainty existed for some taxpayers as to whether an interest in rental real estate rises to the level of a trade or business for purposes of Section 199A. To help mitigate this uncertainty, the IRS issued a proposed version of a revenue procedure (Notice 2019-07)
in January 2019 that included a safe harbor for treating a rental real estate enterprise as a trade or business solely for purposes of Section 199A.
While providing a fundamentally similar safe harbor to the one in Notice 2019-07, Rev. Proc. 2019-38 covers the treatment for mixed-use rental real estate property and includes two additional rental real estate arrangements that are not eligible for the safe harbor. Also, the revenue procedure modifies certain requirements and the information a taxpayer must report with its tax return to rely on the safe harbor for a taxable year.
According to the revenue procedure, 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 a single property or interests in multiple properties. Interests in multiple property can be treated as a single rental real estate enterprise if they are part of the same rental real estate category – residential or commercial. In certain situations, a single building may have both commercial and residential units (i.e., a mixed-use property). The IRS states that an interest in mixed-use property (1) may be treated as a single rental real estate enterprise and not be combined with any other residential, commercial, or mixed-use property or (2) may be bifurcated into separate residential and commercial interests and presumably allowed to be combined with other residential or commercial properties as appropriate.
Rev. Proc. 2019-38, similar to Notice 2019-07, prevents real estate used by the taxpayer or a pass-through’s owner or beneficiary as a personal residence under Section 280A(d) and triple net lease arrangements as being eligible for the safe harbor. The revenue procedure also adds two ineligible types of rental activities – (1) real estate rented to a trade or business conducted by a taxpayer or a pass-through entity which is commonly controlled as defined in the Section 199A regulations and (2) real estate rented to a commonly controlled specified service trade or business.
The revenue procedure also modified the minimum 250-hour service requirement with respect to each rental real estate enterprise. For enterprises that have been in existence less than four years, the hourly requirement must be met on an annual basis. For those in existence for at least four years, the hourly requirements needs to be met in any three of the five most recent taxable years. The IRS also modifies the requirement to maintain contemporaneous records, providing that if the services are performed by employees or independent contractors, the taxpayer may provide a description and amount of time the person generally spends, and the time, wage, or payment records for such person. The revenue procedure added that the contemporaneous requirement will not apply to taxable years prior to Jan. 1, 2020. However, the IRS reminds taxpayers that they still bear the burden of showing the right to any claimed deduction in all taxable years.
A taxpayer or pass-through entity must attach a statement to its timely-filed original return that describes all of the properties (including those acquired or disposed of during the taxable year) in each separate rental real estate enterprise.
The effective date of the revenue procedure applies to taxable years ending after Dec. 31, 2017. However, taxpayers and pass-through entities may rely on the safe harbor set forth in Notice 2019-07 for the 2018 taxable year. It is important to note that the determination to use this safe harbor must be made annually, and failure to satisfy the requirements of the safe harbor does not preclude a taxpayer or the IRS from otherwise establishing that an interest in rental real estate is a trade or business for purposes of Section 199A.
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