United States: Final Pass-Through Deduction Rules Grant Welcome Relief For Rental Real Estate Activities

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.

Background

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:

  1. Separate books and records must be maintained to reflect income and expenses for each rental real estate enterprise.
  2. At least 250 hours of rental services must be performed each year with respect to the rental enterprise.
  3. 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.

  1. 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.

  1. 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.

  1. 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.

  1. 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.

Summary

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.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Sign Up
Gain free access to lawyers expertise from more than 250 countries.
 
Email Address
Company Name
Password
Confirm Password
Position
Industry
Mondaq Newsalert
Select Topics
Select Regions
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions