Revenue Procedure 2019-38 and the Rental Real Estate Safe Harbor under Section 199A
Most classical musicians receive at least some of their income from self-employment. That income may be from teaching private lessons, performing at private events, or even giving public performances.
Self-employment creates additional challenges from an income tax perspective. Self-employed individuals must keep careful track of their business expenses so they can properly compute their income. For a professional violinist, that includes music, strings, instrument repair, and accessories. Self-employed individuals also have to pay self-employment tax equal to the FICA an employer pays for employees.
The Tax Cuts and Jobs Act of 2017 added Section 199A to the Internal Revenue Code. Section 199A allows a deduction of 20 percent of certain non-corporate taxpayers’ “qualified business income” (QBI) from a trade or business. Sole proprietors and small business benefit from Section 199A. Section 199A also benefits some real estate investors and real estate investment structures.
On September 24, 2019, the IRS issued Revenue Procedure 2019-38 (Rev Proc 2019-38). This revenue procedure provides a safe harbor under which income from rental real estate will be QBI.
199A Applied to Real Estate Investments
Under Section 199A rental of real estate is treated as a trade or business provided the owner is an individual. Most of the time, real estate qualifies under Section 199A if the primary purpose for engaging in real estate rental is for income or profit.
Corporations and partnerships aren’t eligible for the Section 199A deduction on their tax returns. However, the shareholders of an S corporation or the partners of a partnership (or limited liability company taxed as a partnership) may be eligible for the deduction,
This article discusses the Rev Proc 2019-38 safe harbor. General discussion of Section 199A and specifics regarding its application to real estate investments are beyond the scope of this article.
Safe Harbor Requirements
The Rev Proc 2019-38 includes these requirements:
The taxpayer must hold its interest in real estate either directly or through a disregarded entity.
The taxpayer must be engaged in a rental real estate enterprise (RREE).
In three of the previous five years, 250 or more hours of rental services per year must have been performed for the RREE. If the RREE hasn’t yet existed for five years, then there must have been 250 or more hours of rental services performed every year since it was formed.
The RREE must maintain separate books and records. If the RREE owns multiple properties, it may maintain records at the property level and consolidate them at the RREE level.
The taxpayer annually elects to rely upon the safe harbor, and the taxpayer or RREE attaches a statement to its tax return containing specific information.
Rental Real Estate Enterprises Under the Safe Harbor
The safe harbor is available only to RREEs. An RREE under Rev Proc 2019-38 is “an interest in real property held for the production of rents.” The real property may be only one property or multiple properties. However, if the RREE consists of multiple properties, they must all be of the same asset class.
Rev Proc 2019-38 recognizes only two real estate asset classes: commercial and residential. For example, a residential property RREE could combine a student housing and apartment buildings, but it could not include a shopping center.
Mixed use properties may be treated as a single RREE or may be split into their residential and commercial uses. So, if a building had stores on its first floor and apartments on the other floors, the owner would have two options. The taxpayer/owner could treat the entire building as a single RREE but couldn’t combine it with other properties. Or, the taxpayer could operate the apartments and the stores as separate rental real estate. If the taxpayer separated the property, then the taxpayer could combine the apartments with other apartment properties the owner owned.
Some real estate rental arrangements cannot qualify as RREE under Rev Proc 2019-38. Those include:
Real estate used by the taxpayer or one of its owners as a residence
Real estate subject to a triple net lease, a lease where the tenant must pay for taxes, fees, insurance, and other maintenance of the property
Real estate used in a trade or business conducted by the taxpayer or an affiliate
Real estate of which any part is a specified services trade or business under Section 199A regulations, including law, accounting, health, performing arts, consulting, investing, athletics, and securities trading
Rental Services Under the Safe Harbor
To qualify for the safe harbor, the RREE must have had 250 hours of rental services provided for three of the last five years – or in every year if the RREE hasn’t been in business for five years). The taxpayer/owner can perform these services. Or, they can be performed by employees, agents, or independent contractors.
Rev Proc 2019-38 doesn’t define rental services, but it does include examples of some things that are rental services:
advertising to lease real estate and negotiating leases
tenant screening, including verifying information in rental applications
daily operation, maintenance, and repair of the property, including the purchase of materials and supplies
property management services, including supervision of employees and independent contractors.
Travel to and from the property isn’t included in rental services. Rev Proc 2019-38 also doesn’t consider investment management activities to be rental services. So, services involved in acquiring, financing, developing or improving, or providing financial statements or reports cannot be included to meet the 250-hour requirement.
Safe Harbor Recordkeeping Requirements
To qualify for the safe harbor in Rev. Proc 2019-38, an RREE must maintain specific records. The RREE must maintain books and records separate from its taxpayer/owner. If the RREE owns multiple properties, it may maintain property-level financial records and consolidate them.
The RREE also must maintain detailed, contemporaneous records documenting compliance with the 250 rental service hour requirement. Those records must include:
Hours of all services
Description of the services performed
Who performed the services
If employees or independent contractors perform rental services, the taxpayer must keep additional records. Those should include an allocation between the rental services and other services performed by the employees or independent contractors, along with time/wage or payment records.
Because Rev Proc 2019-38 was adopted well into 2019, the recordkeeping requirements aren’t mandatory until 2020. However, the IRS likely will require taxpayers to provide similar information to support reliance on the safe harbor on 2018 or 2019 tax returns.
Safe Harbor Tax Return Statement
A taxpayer relying on Rev Proc 2019-38 must attach a statement to its tax return stating that it intends to rely upon the safe harbor. Except for tax year 2018 (where tax returns may have been filed before Rev Proc 2019-38 was released), the taxpayer must attach the statement to its original tax return. The statement cannot be added by amending the tax return.
This statement for each RREE must include:
The address and rental category of each rental real estate property in the RREE
The address and rental category of all rental real estate properties which the RREE acquired or disposed of during the tax year
A representation that the RREE has satisfied all requirements in Rev Proc 2019-38.
Although not stated in Rev Proc 2019-38, the taxpayer also should state its intention to rely upon the safe harbor.
Non-Exclusive Safe Harbor
The Rev Proc 2019-38 safe harbor is nonexclusive. Therefore, taxpayers with rental real estate who don’t meet the safe harbor requirements still may be able to take the 199A deduction.
Still, the twenty-percent Section 199A deduction can be very valuable for investors in income-producing rental real estate. Therefore, all taxpayers should consult with their attorneys and tax advisors to determine whether they can structure their rental real estate holdings to comply with the safe harbor.
© 2019 by Elizabeth A. Whitman
Any references clients and their legal situations have been modified to protect client confidentiality
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