Section 199A, part of the 2017 Tax Cuts and Jobs Act (the “Tax Act”), permits owners of non-corporate businesses to deduct up to 20 percent of the owner’s share of income from the business. Like many of the tax law changes included in the Tax Act, section 199A is a temporary provision, due to expire after 2025.
Section 199A contains several areas of ambiguity and there are numerous questions regarding how the law operates in the context of businesses that operate rental real estate. Recent IRS guidance has helped to clarify how and to what extent the section 199A deduction may apply to rental real estate businesses.
Background on Section 199A
The section 199A deduction is generally available to taxpayers other than corporations. Individuals operating as sole proprietorships, partnerships, S corporations, trusts and estates that carry on a “qualified trade or business” are potentially eligible to claim the deduction. An eligible taxpayer can deduct up to 20 percent of his or her qualified business income defined as the net effectively connected income from a U.S. trade or business. Excluded from the definition of qualified business income are capital gains, dividends and dividend equivalents, interest income, currency gains and gains from notional principal contracts. While most types of investment income are excluded, rents from leasing real estate can qualify for the deduction if the activity rises to the level of a trade or business (as compared with a purely investment activity).
As provided in Treas. Reg. § 1.199A-1(b)(14), the rental or licensing of tangible or intangible property is generally treated as a qualified trade or business undersection 199A if the activity rises to the level of a section 162 trade or business (pertaining to deductions for business expenses). Whether renting real estate rises to the level of a trade or business under section 162 depends on all the facts and circumstances. To be engaged in a trade or business under section 162, the taxpayer must be actively involved in the activity with continuity and regularity and the primary purpose for engaging in the activity must be for income or profit.
Section 199A contains several limitations and restrictions that reduce the availability of the full 20 percent deduction. The first limit phases in reductions to the deduction when the business owner’s taxable income exceeds certain thresholds. For married taxpayers filing a joint return, the limitation phase begins at $321,400 of taxable income for 2019 (indexed for inflation). For taxpayers filing a single or head of household return, the threshold is $160,700 for tax year 2019.
A second restriction limits the amount that can count as qualified business income to formulaic derived amounts based on what the business spent on depreciable property and payroll. The effect of this limitation is that owners of businesses with significant W-2 wages and/or significant investments in depreciable property will benefit the most from the deduction.
Recent IRS guidance pertaining to rental real estate
In September 2019, the IRS released Rev. Proc. 2019-38, providing a section 199A safe harbor for businesses that operate rental real estate. This guidance, finalizing proposed rules in IRS Notice 2019-7, provides that a rental real estate enterprise will be treated as a single trade or business for purposes of the section 199A 20 percent deduction if it maintains separate books and records, the taxpayer performs 250 hours or more of “rental services” per year with respect to the enterprise, maintains contemporaneous records with respect to the rental services, and complies with certain procedural rules.
Rental services are defined to 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 rents; (v) daily operation, maintenance, and repair of the property, including the purchase of materials and supplies; (vi) management of the real estate; and (vii) supervision of employees and independent contractors. Rental services may be performed by owners or by employees, agents, and/or independent contractors of the owners. Rental services do not include financial or investment management activities, such as arranging financing; procuring property; studying and reviewing financial statements or reports on operations; making capital improvements; or hours spent traveling to and from the real estate.
Rev. Proc. 2019-38 makes clear that real estate rented under a triple net lease is not eligible for the safe harbor. A triple net lease is defined as 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. It is worth noting that an enterprise that fails to meet the safe harbor may still qualify under section 199A if the enterprise otherwise meets the definition of trade or business. Recent statements from IRS representatives confirm that the safe harbor is optional and that certain triple net lease arrangements may still qualify as a trade or business under the section 162 trade or business definition notwithstanding that they fail to qualify under the safe harbor.
Owners of rental real estate should determine whether they are eligible for the section 199A deduction and if so, whether they should reconsider their choice of entity if the business is currently operated as a corporation. While the section 199A deduction expires after 2025, it provides a significant tax benefit for owners of qualifying businesses.
Douglas M. Andre serves as a partner at Ivins, Phillips & Barker in Washington, D.C., where he practices estate and gift tax law for high-net-worth individuals, specializing in the international tax obligations of U.S. citizens living abroad and non-U.S. persons residing or investing in the United States. He can be reached at [email protected].