Sometimes the worst thing that happens is when you get what you ask for.  Arguably, CPAs who were asking for guidance on whether a client’s rental was a trade or business for purposes of §199A’s qualified business income deduction ended up in that situation when the IRS released Notice 2019-07 in January 2019 with a draft revenue procedure.  The draft procedure provided a safe harbor test for when the IRS would not challenge the taxpayer’s position that their rental undertaking was a trade or business.

In Revenue Procedure 2019-38[1] the IRS has now finalized that procedure, making some adjustments to the draft procedure but still, arguably, have issued a procedure that only protects rentals that the case law indicates were clearly trades or businesses anyway.

An undertaking is included in the calculation of qualified business income under IRC §199A only if it is incurred in a trade or business as defined in IRC §162.[2]  Whether a rental activity rises to the level of a trade or business is one of the many “it depends” issues under the tax law, but case law going back decades suggests that, in most cases, a rental will rise to a level of a trade or business.

In the case of Fackler v. Commissioner, 133 F.2d 509 (1943) a taxpayer was found to have a trade or business in rental with just a single commercial property.  Similarly, in the case of Hazard v. Commissioner, 7 TC 372 (1946), a single-family residence was all the taxpayer possessed—but renting that out was again held to be a trade or business.  While the Second Circuit Court of Appeals, in the case of Grier v. United States, 120 F.Supp. 395 (1954), affd, CA2 218 F. 2d 603 (1955) refused to go as far as the courts in Hazard and Fackler with a single rental, the Circuit has pretty much stood alone on this issue.

The types of rentals that have traditionally not been held to be a trade or business have been a single triple net lease (see Revenue Ruling 73-522).  But even triple-net leases, if a taxpayer has enough of them, can rise to a trade or business as was discussed on our website early in 2019.[3]

The proposed, and now final, Revenue Procedure was issued in response to complaints that taxpayers were finding it confusing to determine if their rental was a trade or business.  So, the IRS issued a safe harbor that was intended to address only the most obvious cases where a taxpayer had a trade or business in his/her rental undertaking. 

The procedure is merely a safe harbor, not a bright line test that divides trade or business activities from those that are not such.  The IRS added language to the final revenue procedure to make it clear this was never meant to be used to give the final answer:

Failure to satisfy the requirements of this safe harbor does not preclude a taxpayer or the Service from otherwise establishing that an interest in rental real estate is a trade or business for purposes of section 199A.[4]

That line saying that the Service is not precluded from arguing the rental is a trade or business if the taxpayer fails this test is a warning—since gains treated as capital gains are not part of QBI (such as §1231 gains if such gains are in excess of losses and there’s no recapture of prior §1231 losses)[5] but the carried over post-2017 passive losses released on the sale of a trade or business are, the IRS clearly will often be ahead by arguing a rental is a trade or business—and arranging a taxpayer’s affairs to barely fail the safe harbor will almost certainly fail to protect the taxpayer from the IRS treating the rental activity as a trade or business, using the released loss to reduce the taxpayer’s QBI from profitable trades or businesses.

One significant change in the final revenue procedure involves the issue of “mixed-use” rental properties.  Generally, under the Revenue Procedure, the taxpayer tests rental enterprises for meeting the requirements of the safe harbor.  Taxpayer can treat each rental as an enterprise on its own, or the taxpayer can combine similar properties into an enterprise.  Under the Revenue Procedure similar properties generally must be all commercial properties or all residential properties.  As well, commercial properties cannot be combined with residential properties normally into a single enterprise[6]

Example

Greg owns four single family homes and three office buildings that he rents.  Greg can treat all the single-family homes as a single enterprise and all the office buildings as a second enterprise under the Revenue Procedure.

However, Greg is not allowed to combine all seven properties into a single enterprise for purposes of the Revenue Procedure.

Several commentators noted that there are numerous buildings, especially in urban downtown areas, where a building has both commercial properties (often on the ground floor) and residential properties (normally on the upper floors).  In such a case, it wasn’t clear if the draft revenue procedure required the taxpayer to split the single property into two components, or if that property could be a single enterprise.

The final procedure provides some clarification and choice, indicating:

An interest in mixed-use property may be treated as a single rental real estate enterprise or may be bifurcated into separate residential and commercial interests. For purposes of this revenue procedure, mixed-use property is defined as a single building that combines residential and commercial units. An interest in mixed-use property, if treated as a single rental real estate enterprise, may not be treated as part of the same enterprise as other residential, commercial, or mixed-use property.[7]

If a taxpayer decides to combine like properties into a single enterprise, the taxpayer must combine all such like properties.  Once the taxpayer chooses to treat the properties as a single enterprise, the taxpayer must continue to do so under the Revenue Procedure in future years, as well as add any new properties of that type to the enterprise in future years.  However, if a taxpayer does not initially combine the like properties into a single enterprise, the taxpayer may elect to combine all similar properties in a later year.[8]

Example

Greg does not treat the four residential properties as a single enterprise on his 2018 return.  Even though he did not combine them into a single enterprise on his 2018 return, he can decide to treat them as one enterprise on his 2019 return.

But if Greg had treated the residential properties as a single enterprise on the 2018 return, he cannot decide to treat them as separate enterprises in 2019 or any later year.  As well, if he acquires a new residential rental in 2019 or later years, he will be required to add that rental to the enterprise.

As with the draft revenue procedure, under the final procedure the determination for qualification under the revenue procedure is made annually.  If all the following requirements are met, the IRS will not challenge the taxpayer treating the rental enterprise as a trade or business:

• Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise.  Note, the final procedure added the following: if a rental real estate enterprise contains more than one property, this requirement may be satisfied if income and expense information statements for each property are maintained and then consolidated;

• For rental real estate enterprises that have been in existence less than four years, 250 or more hours of rental services are performed (as described in this revenue procedure) per year with respect to the rental real estate enterprise.  For rental real estate enterprises that have been in existence for at least four years, in any three of the five consecutive taxable years that end with the taxable year, 250 or more hours of rental services are performed (as described in this revenue procedure) per year with respect to the rental real estate enterprise; and

• The taxpayer maintains 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.  If services with respect to the rental real estate enterprise are performed by employees or independent contractors, the 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.  Such records are to be made available for inspection at the request of the IRS.[9]

If the taxpayer qualifies and wishes to take advantage of the safe harbor, the revenue procedure requires attaching the following to the tax return:

The taxpayer or RPE attaches a statement to a timely filed original return (or an amended return for the 2018 taxable year only) for each taxable year in which the taxpayer or RPE relies on the safe harbor.  An individual or RPE with more than one rental real estate enterprise relying on this safe harbor may submit a single statement but the statement must list the required information separately for each rental real estate enterprise.  The statement must include the following information:

(1) A description (including the address and rental category) of all rental real estate properties that are included in each rental real estate enterprise;

(2) A description (including the address and rental category) of rental real estate properties acquired and disposed of during the taxable year; and 

(3) A representation that the requirements of this revenue procedure have been satisfied.[10]

Rental services for purposes of the 250-hour test include, but are not limited to, the following items:

• 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.[11]

However, such rental services do not include financial or investment management activities.  The procedure provides the following example of such services that cannot be used to meet the 250-hour test:

• Arranging financing; procuring property;

• Studying and reviewing financial statements or reports on operations;

• Improving property under § 1.263(a)-3(d); or

• Hours spent traveling to and from the real estate.[12]

The procedure also bars taxpayers from including the following rentals in an enterprise, and thus they cannot qualify to use the safe harbor as only enterprises are tested under the safe harbor:

• Real estate used by the taxpayer (including an owner or beneficiary of an RPE) as a residence under section 280A(d); 

• Real estate rented or leased under a triple net lease.  For purposes of this revenue procedure, a triple net lease includes a lease agreement that requires the tenant or lessee to pay taxes, fees, and insurance, and to pay for maintenance activities for a property in addition to rent and utilities;

• Real estate rented to a trade or business conducted by a taxpayer or an RPE which is commonly controlled under Reg. §1.199A-4(b)(1)(i);

• The entire rental real estate interest if any portion of the interest is treated as a specified service business (SSTB) under Reg. §1.199A-5(c)(2) (the anti-crack and pack rules which would apply if the property is leased to a controlled SSTB).

The procedure is effective for tax years beginning after December 31, 2017, though for 2018 taxpayers may rely on the draft revenue procedure found in Notice 2019-07 if they prefer.[13]

The procedure also extends the limited relief from the strict contemporaneous records requirement for the 250-hour rule for one more year, first applying to years beginning on or after January 1, 2020.  However, the ruling contains following caution regarding this break:

…[T]axpayers are reminded that they bear the burden of showing the right to any claimed deductions in all taxable years.  INDOPCO, Inc. v. Comm’r, 503 U.S. 79, 84; 112 S.Ct. 1039, 1043) (1992); Interstate Transit Lines v. Comm’r, 319 U.S. 590, 593, 63 S.Ct. 1279, 1281 (1943).  See also I.R.C. § 6001; Treas. Reg. § 1.6001-1(a) and (e).[14]

Again, advisers must remember this is only a safe harbor and that a large number, arguably the majority, of rentals that cannot pass this test will nevertheless be a §162 trade or business subject to the §199A rules, for better or worse.

[1] Revenue Procedure 2019-38, September 24, 2019, https://www.irs.gov/pub/irs-drop/rp-19-38.pdf (retrieved September 24, 2019)

[2] Reg. §1.199A-1(b)(14)

[3] Edward K. Zollars, “Can an LLC Operating a Shopping Center with Triple Net Leases for All Tenants Give Rise to Qualified Business Income?” Current Federal Tax Developments website, February 23, 2019, https://www.currentfederaltaxdevelopments.com/blog/2019/2/23/can-an-llc-operating-a-shopping-center-with-triple-net-leases-for-all-tenants-give-rise-to-qualified-business-income, retrieved September 24, 2019.

[4] Revenue Procedure 2019-38, Section 3.01

[5] Reg. §1.199A-3(b)(2)(ii)

[6] Revenue Procedure 2019-38, Section 3.02

[7] Revenue Procedure 2019-38, Section 3.02

[8] Revenue Procedure 2019-38, Section 3.02

[9] Revenue Procedure 2019-38, Section 3.03

[10] Revenue Procedure 2019-38, Section 3.03(D)

[11] Revenue Procedure 2019-38, Section 3.04

[12] Revenue Procedure 2019-38, Section 3.04

[13] Revenue Procedure 2019-38, Section 4

[14] Revenue Procedure 2019-38, Section 4