The IRS Offers Safe Harbor Deduction For Rental Real Estate Investors

A safe harbor reduces regulatory liability in specific situations as long as certain conditions have been met, and now the IRS provided rental real estate businesses a safe harbor to claim an interest in the property as a qualified business deduction.

With Revenue Procedure 2019-38, this tax break under Section 199A of the Tax Cuts and Jobs Act provide owners of rental real estate the ability to claim the same for up to 20% of income from a pass-through business.

The safe harbor now permits some real estate interests (even interests in mixed-use property) to be treated as a trade or business for the sake of the QBID.

As soon as the requirements of the safe harbor are met, an interest in real estate will be treated as a single trade or business for purposes of a Section 199A deduction – and even if the investment in real estate does not meet the requirements of the safe harbor, it can still be treated as a trade or business for purposes of a 199A deduction if it otherwise meets the definitions provided in the Section 199A regulations.

Specifically for the safe harbor, the IRS defines a rental real estate as an interest in real property held to generate rents; it may consist of single or multiple properties, but the taxpayer has to hold every interest directly or through a disregarded entity separated from its owner.

Requirements To Qualify For The Safe Harbor

1. Separate books and records for every rental real estate enterprise.
2. Enterprises that are less than four years old need to spend 250 or more hours per annum on rental services.
3. Enterprises older than four years 250-hours of rental services per annum in three of the past five years.
4. Contemporaneous records that include time logs that capture the total rental service hours, a description of all rental services provided, the dates of the same, and the identity of the person responsible for the provision of the same.
5. When filing tax returns, a statement has to be included to indicate which years the safe harbor is relied upon.

One requirement for treatment as a trade or business is that the real estate enterprise spent at least 250-hours per year providing rental services. Over four years, if the enterprise meets the 250-hour requirement for three of the consecutive five years up to the end of the tax year, the enterprise will qualify. For those enterprises that do not meet the requirements under the new provisions, they will still be eligible for QBID if they meet the requirements separately in terms of Section 199A regulations.

According to the IRS, the owners cannot count the time they spent in their capacity as an investor procuring property, arranging finance, reviewing financial statements and reports, and traveling to and from properties, towards rental service hours. What counts are hours spent in providing services, albeit by the owner or his agents or independent contractors doing maintenance and repairs, collecting rent and paying expenses, providing services to tenants, and renting out the property.

As for the definition of a rental real estate enterprise for purposes of the safe harbor, it is an interest in real property held for the production of rents. The enterprise may keep multiple properties if the properties are owned directly or via a disregarded entity as long as the taxpayer treats each property held for the production of rents as a separate enterprise, OR if the taxpayer handles all similar properties owned for the production of rents as a single enterprise. Notably, commercial and residential real estate cannot be held in the same enterprise, and property held under a triple net lease or ever used for residential purposes (like a vacation home) is not eligible under the safe harbor provisions.

Records and books have to be kept separately and contemporaneously and should include logs of the following:

• All service hours
• All service descriptions
• All service dates
• All service providers’ identities

When the taxpayer or passthrough entity files returns, it has to attach a statement for the tax years safe harbor is relied upon. Although the contemporaneous service record requirement starts in 2020, taxpayers have to supply proof of entitlement for any deductions claimed.

What Can You Do If You Do Not Meet The Safe Harbor Requirements

If your enterprise does not meet the requirements for the safe harbor set out below, you can still benefit from the 20% deduction.

1. Can you make any changes to your rental enterprise, operations, or lease agreements to meet the requirements?
2. There are instances where it is to your advantage not to achieve “business” status. If your rental enterprise generates a loss that would reduce the 20% deduction, you might be better off without a business classification.
3. However, consider whether your enterprise should qualify as a business:
   • Are your rental properties for commercial or residential purposes?
   • How many properties are rented?
   • What is the involvement of the owner and his agents?
   • Carefully consider the ancillary services provided in terms of the lease agreement.
   • The nature of the lease: Is it a net lease or a traditional lease? Is it short-term or long-term?
4. Does the self-rental rule apply?

To be eligible for the 20% qualified business income deduction (QBID) you have to meet some requirements:

Separate records and books must be kept for every rental real estate enterprisePerform 250 or more hours of rental services each yearIf the enterprise is older than four years, 250 hours or more of rental services must have been provided each year for three of the five years ending with the tax year.

Rental services can be provided by:

· Agents

· Employees

· Independent Contractors

· Owners

A rental real estate enterprise can include multiple properties, but it must conform to the same general category, either:

· Commercial

· Residential

Rental Services include:

· Advertizing

· Day to day operations including maintenance and repairs

· Lease negotiations & agreements

· Management of the property

· Purchasing materials

· Rent Collection

· Supervision of employees and contractors

Rental Services exclude

· Finance arrangement

· Financial/Investment management services

· Operating Report Reviews

· Financial Statement Reviews

· Procurement of property

· Travel time remuneration to and from the property

To satisfy the 250-hour requirement, extensive documentation is required for every property in respect of:

· Dates Services were provided

· Description of services rendered

· Identity of person who performed the services

· Hours spent on delivering the services

EXCLUDED FROM 199A TREATMENT: Four categories of property are excluded from 199A treatment irrespective of meeting the above criteria.Property ever used residentially, including vacation homesSelf-rentals – where real estate is rented to a business with shared ownershipIn the event of a triple-net-lease (Tenant pays taxes, insurance, and maintenance)Property under nuance rule – where a part of real estate is treated as a specified service business under the nuance rule.

The new rules help by simplifying some of these requirements. For example, in respect of the substantiation of time spent, taxpayers can benchmark the amount of time generally spent on similar services instead of keeping detailed time logs – if – the taxpayer retains complete records (time; wage & payment).