On September 24, 2019, the Treasury Department finalized a safe harbor for rental real estate activities which should provide some tax benefits for lessors and investors.
We addressed the draft safe harbor in a previous tax blog posting which can be found here.
In this posting, we provide a summary of the final version of the safe harbor and recommendations for maximizing the benefits available under it.
IRC 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 regulations issued in connection with IRC 199A, 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 of underlying real estate assets.
The Safe Harbor – General
On January 18, 2019, the government proposed a safe harbor for rental real estate to address this uncertainty. On September 24, 2019, the safe harbor was finalized with some minor changes.
If a taxpayer’s rental real estate activity meets the safe harbor, then it will be treated as a trade or business for purposes of 199A. Thus, the profits from such operations will be taxed at lower rates.
The safe harbor sets out four requirements that must be met, and includes several exclusions and caveats. We address each of these in detail below.
The Safe Harbor – Specific Requirements
The safe harbor sets out four requirements:
- Separate books and records must be maintained to reflect income and expenses for each rental real estate enterprise (“RREE”).
- At least 250 hours of rental services must be performed each year with respect to each RREE.
- 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.
- The taxpayer must attach a statement to a timely filed original return (or in the case of the 2018 tax year only, an amended return) for each taxable year in which the taxpayer relies on the safe harbor.
Because most businesses already maintain separate books for each real estate activity, the first requirement should be easy to satisfy. Note that the safe harbor also contains rules that permit a taxpayer to aggregate separate properties and treat them as a single RREE (see discussion below). In that case, this requirement can be satisfied if income and expense information statements for each property are maintained and then consolidated.
Each RREE must satisfy the 250-hour requirement. Note that an extensive definition of “rental services” is set forth in the safe harbor. Specifically, rental services include:
- 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, including the purchase of materials and supplies;
- management of the real estate; and
- 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.
Although the above list does not purport to be exhaustive, the safe harbor specifically excludes the following activities: financial or investment management activities, such as arranging financing; procuring property; studying and reviewing financial statements or reports on operations; improving property under §1.263(a)-3(d); and hours spent traveling to and from the real estate.
The 250-hour requirement is an annual requirement, but the safe harbor relaxes this once an RREE has been in existence for at least four years. At that point, the 250-hour requirement need only be satisfied in any three of the five consecutive years ending with the taxable year.
Contemporaneous Documentation Requirement
The safe harbor specifically provides that the contemporaneous documentation requirement does not apply tax years prior to 2020. However, the burden of proof is still on the taxpayer, so it will be important to gather and preserve such documentation even if it does not occur contemporaneously.
The safe harbor contains specific language that a taxpayer may provide a description of the rental services performed by such employee or independent contractor, the amount of time such employee or independent contractor generally spends performing such services for the enterprise, and time, wage, or payment records for such employee or independent contractor. Unfortunately, the effect of this language is unclear. Given the reminder in the safe harbor about the taxpayer’s burden of proof, it is uncertain whether the above language is meant as a statement of the necessary level of proof or something less than that. Until more clarity is provided, detailed information from vendors and employees should be obtained to document actual hours.
Tax Return Statement
The safe harbor cannot be utilized unless the taxpayer attaches a statement to its tax return. Note that the statement must be attached to the original return (with the exception of the 2018 tax year).
If a taxpayer has more than one RREE, the statement must list the required information separately for each RREE. The statement must include the following information:
- a description (including the address and category (commercial, residential, mixed-use)) of all rental real estate properties that are included in each RREE;
- a description (including the address and rental category) of rental real estate properties acquired and disposed of during the taxable year; and
- a representation that the requirements of the safe harbor have been satisfied.
Aggregating Separate Properties
As noted, the safe harbor contains a grouping rule that can both help and hurt taxpayers. This would help taxpayers in cases where the 250-hour requirement cannot be satisfied for an individual property but can be satisfied on an aggregate basis.
Generally, a taxpayer may only aggregate “similar” properties. For these purposes, commercial and residential properties are not treated as similar. Thus, a taxpayer can aggregate all its commercial properties as a single RREE and/or it can aggregate all its residential properties as a single RREE, but cannot aggregate commercial and residential properties with each other.
Once a taxpayer treats interests in commercial properties or residential properties as a single RREE under the safe harbor, the taxpayer must continue to treat interests in all similar properties, including newly acquired properties, as a single RREE to the extent that the taxpayer continues to rely on the safe harbor.
However, a taxpayer that chooses to treat its interest in each residential or commercial property as a separate RREE may choose to treat its interests in all similar commercial or all similar residential properties as a single RREE in a future year.
Mixed-use properties are treated differently. An interest in mixed-use property may be treated as a single RREE or may be bifurcated into separate residential and commercial interests. However, such a project cannot be aggregated with other mixed-use properties.
For purposes of the safe harbor, mixed-use property is defined as a single building that combines residential and commercial units.
As noted in our previous posting, these grouping rules appear to be arbitrary. The safe harbor does not cite any rationale for preventing a taxpayer from aggregating commercial and residential real estate activities, or aggregating mixed-use properties.
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.
The safe harbor by its terms only applies to real estate held for the production of rents (i.e., rental real estate). Thus, many other real estate development business models may not come within the safe harbor.
- 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 pay for maintenance activities for a property in addition to rent and utilities.
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, base rent would be increased by the projected expense of the maintenance obligation. Note that 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 the safe harbor) as a residence.
- Real Estate Leased to an Affiliated Trade or Business.
The safe harbor does not apply to real estate that is leased to a trade or business that is owned by affiliated parties. This type of arrangement is excluded because the regulations under IRC 199A already provide that this type of rental activity will be treated as a trade or business.
The safe harbor may be helpful for some taxpayers, but it also creates new challenges. Taxpayers will need to consider the following:
- Triple-Net Leases
Taxpayers should consider re-negotiating existing rental arrangements that could be characterized as triple-net leases and avoiding triple-net leases for new tenants. As noted above, perhaps the easiest modification would be to shift the maintenance obligation to the lessor. This would keep the arrangement from being treated as a triple-net lease and would let the lessor count all maintenance activities toward the 250-hour requirement.
- Contemporaneous Documentation – 2018 and 2019
Although the language of the safe harbor suggests that the taxpayer can determine some of the facts necessary to meet the 250-hour requirement, the better course is to get invoice-level documentation from vendors. In some cases, invoices will provide sufficient detail to determine the hours expended, but in other cases it will be necessary to have the vendor certify this information. The sooner this information is requested the more likely a vendor will be able to provide a detailed response.
- Contemporaneous Documentation – 2020 and afterwards
Going forward, it makes sense to require that vendors provide invoice-level disclosure of the hours expended, broken out by property. This type of documentation should be a condition of being paid.
- Aggregation Analysis
2018 will be the first tax year for which the safe harbor can apply. It is important to consider whether and to what extent aggregation would be beneficial to a taxpayer. Once a taxpayer elects to aggregate for a given class of properties, it will be stuck with that choice going forward.
Similarly, it will be important to determine whether to bifurcate a mixed-use property or treat it as a separate RREE.
Along these lines, it may be worth considering whether the commercial elements of a mixed-used project could be physically separated so as to take the project out of the mixed-use category altogether.
For more information regarding the safe harbor, please contact Joseph Mandarino.