Safe harbor! It sounds wonderful.
Obviously, you are going to be comfortable in a safe harbor. And if you said you don’t want comfort, you might be thought of as a little loony.
You may sense that we are not jumping with joy about this new safe harbor for Section 199A rental property. It’s true; our joy quotient is a little low on this safe harbor because of the work involved.
Our feeling is that you did this work, so your property is a trade or business with no safe harbor needed. Of course, the safe harbor gives you comfort, so we need to examine what’s involved.
With the new safe harbor, the IRS thinks it is your new friend when it comes to claiming the Section 199A 20 percent tax deduction on your rental real estate profits.
Your new friend created a fork in the road by giving you an alternative method for finding out whether your rentals qualify for the new 20 percent tax deduction. So now you have a choice between the following two methods:
- Claim that the rentals are trades or businesses under existing law.
- Use the new safe-harbor rules.1
When you meet the new safe-harbor rules, the IRS deems your rental a trade or business with net rental profits that are qualified business income (QBI) for the Section 199A tax deduction.
But you may not want to use the safe-harbor rules, because they contain some onerous provisions. Also, you may not qualify to use the safe harbor. No problem. You can simply use the second method and win your 199A tax deduction using the existing trade or business tax law rules.
New Tax Term—Rental Real Estate Enterprise
Under the new Section 199A rental real estate safe harbor (and only for this Section 199A safe harbor), each of your rental real estate properties individually or as a group (if you so choose) falls into one of the following categories:2
- Residential real estate enterprise
- Commercial real estate enterprise
- Triple net lease real estate
Grouping rule. You (or your pass-through entity) must either3
- treat each rental property as a separate enterprise,
- or treat all similar properties as a single enterprise.
Example. Fred has 10 rentals; eight are residential, and two are commercial. None are triple net lease. With grouping, Fred has two enterprises: one residential and one commercial.
With grouping of the residential and no grouping of the commercial, Fred has three enterprises: residential, commercial 1, and commercial 2.
Under this safe harbor, you may not vary your enterprise treatment from year to year unless you have a significant change in circumstances.4
(Reminder: You don’t have to use the safe-harbor rules for your rental properties. You can use the historical trade or business rules to qualify your rental property for the Section 199A deduction.)
Solely for Section 199A purposes, the IRS will treat your rental real estate enterprise as a trade or business if you (or your pass-through entity) can satisfy the following requirements:5
- You maintain separate books and records that reflect the income and expenses of each rental real estate enterprise.
- You perform 250 or more hours of “rental services” during the tax year.6
- You 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. (Note: The contemporaneous records rule does not apply to tax years beginning before
January 1, 2019—but don’t let this give you false hope; you still need proof.)
Qualifying defined “rental services” can be done by you, your employees, your agents, and/or your independent contractors. Such services include7
- advertising to rent or lease the real estate;
- negotiating and executing leases;
- verifying information contained in prospective tenant applications;
- collecting rent;
- maintaining, repairing, and daily operation of the property;
- managing the real estate;
- purchasing materials; and
- supervising employees and independent contractors.
Rental services that do not qualify for the safe harbor include8
- financial or investment management activities, such as arranging financing, procuring property, or studying and reviewing financial statements or reports on operations;
- planning, managing, or constructing long-term capital improvements; and
- hours spent traveling to and from the real estate.
Reminder. The safe-harbor rules above are solely for Section 199A purposes.
Beware. The passive-activity rules for material participation and status as a real estate professional contain many differences from what you see for the Section 199A tax deduction.
Time log. Your number-one important record for obtaining hassle-free tax deductions on your rental real estate is an accurate and provable time log. If you are using the new Section 199A safe harbor, you now have one additional reason to track time spent.
Nonqualifying Real Estate
Triple net lease property does not qualify for the safe harbor. Remember, the safe harbor is not the only method you can use to qualify your rental real estate for the Section 199A tax deduction. For more on triple net leases, see Q&A: Do Triple-Net Leases Qualify for a 199A Deduction?
Also, you may not use the safe harbor on real estate that you use as a residence. If you have a vacation home, Section 280A makes that vacation home either a rental property or a residence.9
The Safe Harbor Requires Tax Return Disclosure and a Signed Statement under Penalties of Perjury
You or your pass-through entity must attach a statement to the tax return stating that you are using the safe harbor and you satisfied the requirements set forth in Section 3.03 of Rev. Proc. 2019-XX (the requirements we listed above).10
You (or an authorized representative) must have personal knowledge of the facts and circumstances required by the statement above and then assert to the IRS that you have this knowledge with the following declaration:
Under penalties of perjury, I (we) declare that I (we) have examined the statement, and, to the best of my (our) knowledge and belief, the statement contains all the relevant facts relating to the revenue procedure, and such facts are true, correct, and complete.
Trade or Business Route Avoids the Safe Harbor
The preamble to the IRS’s new final regulations on Section 199A has this to say about rental real estate:11
Providing bright line rules on whether a rental real estate activity is a section 162 trade or business for purposes of section 199A is beyond the scope of these regulations.
This means that if you don’t want to use the safe harbor, you need to employ the existing tax law rules on when a rental is a trade or business. For some insights on this, see New IRS Regs: Does Your Rental Qualify for a 199A Deduction?
Safe Harbor—No 1099 Issues
If you use the safe harbor, your rental is a business regardless of whether you send 1099s to service providers.
In its preamble to the final Section 199A regulations, the IRS notes that the law requires a trade or business to send 1099s to certain service providers. For more on this possible complication, see For 199A Tax
Deductions, Must Landlords Give 1099s to Vendors?
You may not find it easy getting to the safe harbor. But remember once you are inside the safe harbor, you have the comfort of knowing that your rental properties are business properties for the possible 20 percent tax deduction under Section 199A.
Now, because of the safe harbor, you have a choice:
- use the safe harbor as described in this article, or use the existing tax code trade or business rules to prove that your rental is a trade or business.
- And remember, once you are inside the safe harbor, the fact that you did or did not issue 1099s to your service providers is moot for purposes of the Section 199A tax deduction.
Section 199A: Qualified Business Income Deduction
How to Broker Better Tax Breaks on Rental Properties
7 Tips to Ensure Your Business Earns the 20% QBI Tax Deduction
2018 Year-End Tax Planning for Businesses
1 Notice 2019-7.
6 For taxable years beginning after December 31, 2022, you can meet the 250-hours test in any three of the preceding five years.
7 Notice 2019-7.
9 IRC Section 280A.
10 Notice 2019-7 contains the requirement that will exist in the Rev. Proc. when the IRS issues it. For now, you have Rev. Proc. 2019-XX.
11 Preamble to Final Section 199A Regulations (released Jan. 18, 2019), p. 16.