On Friday, January 18, 2019, the Treasury Department issued final rules under IRC Section 199A. As part of this regulation package, Treasury also provided much-needed relief and clarity for rental real estate activities. This development creates some hope that similar rules may be in store for Opportunity Zone Funds.
IRS Section 199A is a tax incentive for pass-through entities and sole proprietorships. It effectively reduces the federal tax rate on income arising from certain activities by as much as 20%. Thus, if income from an activity qualifies, a taxpayer who would otherwise pay taxes at the current top federal rate of 37% would only pay tax on such income at a federal rate of about 30%.
However, Section 199A only applies to an activity that is a “trade or business.” This is a term of art that is not explicitly defined in the IRC and for which vague guidance can be found in case law. In general, the case law would suggest that many real estate activities might not qualify under this definition. Moreover, in the proposed regulations issued by the government in August of 2018, no effort was made to provide clarity on the application of this term to real estate activities.
Real estate owners, developers, and investors thus faced uncertainty as to whether the incentives under 199A would apply to them. Because economic decisions are generally made on an after-tax basis, the effect of this uncertainty could result in price degradation in a market that is already strained.
The Safe Harbor – General
On January 18, 2018, the government issued final regulations and in addition announced a Revenue Procedure that carves out a safe harbor for rental real estate. Demonstrating a gift for understatement, the document prefaces the new rules by stating that the “Treasury Department and the IRS are aware that whether a rental real estate enterprise is a trade or business for purposes of section 199A is the subject of uncertainty for some taxpayers.”
The gist of the proposed relief is to create a safe harbor under which rental real estate will be treated as a trade or business for purposes of 199A. Thus, operations that meet the safe harbor will qualify for the incentive and the profits from such operations will be taxed at lower rates.
The safe harbor sets out three main requirements that must be met, and includes several exclusions or caveats. We address each of these in detail below.
The Safe Harbor – Specific Requirements
The safe harbor sets out three requirements:
- Separate books and records must be maintained to reflect income and expenses for each rental real estate enterprise.
- At least 250 hours of rental services must be performed each year with respect to the rental enterprise.
- The taxpayer must maintain 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 must be made available for inspection at the request of the IRS.
Because most businesses already maintain separate books for each real estate activity, the first requirement should be easy to satisfy.
The second and third requirements may be more difficult to meet. Note that an extensive definition of “rental services” is set forth in the safe harbor. Specifically, rental services 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.
Moreover, rental services can be performed by owners, employees, agents, and/or independent contractors of the owners. Thus, unlike the passive activity rules that require the taxpayer or a spouse to work a certain number of hours in the activity each year, this requirement is met even if the services are carried out by a third party. Accordingly, it will become very important that vendors who perform services that could be counted towards the 250-hour requirement provide documentation. It may be necessary to condition payment to the vendor on the receipt of such records.
Although the above list is not stated as exclusive, the safe harbor specifically excludes 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.
The 250-hour requirement is an annual requirement, but the safe harbor relaxes this starting in 2023. At that point, the 250-hour requirement need only be satisfied in any three of the five consecutive years ending with the taxable year.
Finally, the contemporaneous documentation requirement does not appear to apply to the 2018 tax year. (However, the wording here is ambiguous. The government may mean that documentation is always required, but that the 2018 documentation can be created after the fact.)
The Safe Harbor – Exclusions
The safe harbor sets out a number of exclusions, each of which is addressed below.
- The safe harbor only applies to rental real estate.
Thus, many traditional forms of real estate development may not come within the safe harbor. This triggers three observations at first blush.
First, in some cases traditional development activities can qualify as a trade or business under the vague standards of the case law. Documenting these activities and the hours involved will be helpful in proving this.
Second, because of the benefit of coming within the safe harbor, it may be worth considering adjustments to the business model to come within the rental real estate limitation.
Third, if the activity does not qualify as rental real estate but is designed to result in a disposition at long-terms capital gains rates, then the incentive may not apply in any event. In general, the 199A benefit does not apply to income taxed as long-term capital gains.
- The safe harbor does not apply to triple net leases.
The safe harbor excludes real estate rented or leased under a triple net lease.
For these purposes, a “triple net lease” includes a lease that requires the lessee to pay taxes, fees, and insurance, and to be responsible for maintenance activities for a property in addition to rent and utilities. It also includes a lease that requires the lessee to pay a portion of the taxes, fees, and insurance, and to be responsible for maintenance activities allocable to the portion of the property rented by the tenant.
Note that this limitation may be very difficult to stomach for many existing rental real estate arrangements. One solution may be to amend existing leases to eliminate maintenance activities. In exchange, the projected expense would be built into the rents. (A pure pass-through of maintenance expenses incurred by the lessor may not work.) In this regard, if the lessor takes on maintenance activities, then these activities would appear to meet the definition of rental services and thus facilitate achievement of the 250-hour requirement.
- The safe harbor does not apply to owner residences.
The safe harbor does not apply to real estate used by a taxpayer or any owner or beneficiary of a pass-through entity relying on this safe harbor as a residence for any part of the year.
- The safe harbor grouping rules.
The safe harbor contains a grouping rule that can both help and hurt taxpayers.
In general, a taxpayer must either (a) treat each property held for the production of rents as a separate enterprise, or (b) treat all similar properties held for the production of rents as a single enterprise. This would help taxpayers in cases where the 250-hour requirement cannot be satisfied for individual rental arrangements, but can be satisfied on an aggregate basis.
However, the safe harbor goes on to stipulate that commercial and residential real estate may not be aggregated. This may make it harder to satisfy the 250-hours requirement. For example, assume a taxpayer has two rental activities, one of which is commercial real estate for which 150 hours of rental services are performed each year, and one of which is residential real estate for which 100 hours of rental services are performed each year. The taxpayer does not appear to meet the 250-hour requirement because the activities cannot be aggregated. The safe harbor does not cite any rationale for preventing a taxpayer from aggregating commercial and residential real estate activities.
The safe harbor may be very helpful for some taxpayers, but it also creates new challenges. For example, the exclusion for triple-net leases means that some existing leases may need to be restructured. In addition, new documentation requirements may need to be instituted. Finally, the failure to permit aggregation of commercial and residential real estate may make it more difficult to meet the 250-hour requirement.
On a side note, the apparent willingness of the government to treat real estate as a trade or business for 199A purposes may indicate that the government will provide similar relief in the context of Opportunity Zone Funds (“OZFs”). Like IRC 199A, the incentives that flow from an OZF are also contingent on the existence of a trade or business. Specifically, an OZF generally must invest in a trade or business. Some observers feel that the use of OZFs has likely been hobbled by the fact that neither the statute nor the government’s proposed regulations provide any explicit guidance on whether and to what extent real estate activities will qualify as a trade or business for these purposes. A similar safe harbor could quickly ramp up the use of OZFs.
For more information regarding the safe harbor, please contact Joseph Mandarino.