The Shifting Safe Harbor Under IRC Section 199A

Owners of rental property will have an easier time determining if they’re a trade or business entitled to a 20% deduction for qualified business income under Internal Revenue Code Section 199A, thanks to the recently issued Revenue Procedure 2019-38. Rev. Proc. 2019-38 brings better stability and slightly more taxpayer friendly rules to a great many landlords who’ve taken entrepreneurial risk and responsibilities that should enable them to enjoy the same tax advantages that are provided for larger operations.

One requirement under IRC Section 199A is that there be an active trade or business that generates the income, and the final regulations that were released early this year make it clear that the historical test of whether an activity is an active trade or business under IRC Section 162 will apply.

There’s a great deal of case law under Section 162, but outcomes for landlords haven’t been consistent, so taxpayers who are landlords faced uncertainty.

Safe Harbor

In January 2019, the IRS issued a Notice that proposed that for landlords to qualify, they must spend at least 250 hours on rental activities to be considered to be engaged in an active trade or business (the Safe Harbor).

The Safe Harbor counts the hours of both the owner or owners, and any agents, employees and contractors who render services with respect to the property.

The Notice also contained other proposed provisions concerning the Safe Harbor.

What It Says

Rev. Proc. 2019-38 provides some important details about the Safe Harbor and makes some changes from what was proposed in the Notice:

1. Triple net lease arrangements won’t be allowed to qualify under the Safe Harbor, although some triple net lease arrangements will be active enough to qualify as a trade or business without using the Safe Harbor.

The Notice’s definition of a “triple net lease” could be read to treat a lease as being “triple net” if the tenant was responsible for a portion of the expenses for taxes, fees and insurances and was required to maintain the property, even if the landlord had some responsibility.  Under Rev. Proc. 2019-38, a lease won’t be considered to be “triple net” if the landlord makes a significant contribution in any of these categories.

2. It appears that non-owner hours don’t need to be exactly counted or contemporaneous under Rev. Proc. 2019-38.  The Notice had required that contemporaneous records be kept about amount of time actually spent by the owner and all contractors and agents thereof.  This would have been unmanageable, because repair people and other third parties typically don’t charge by the amount of time spent, and many of them wouldn’t have accommodated a request to account for time spent.  Now, the taxpayer may provide a description of the rental services provided by the employee/contractor, the amount of time the employee/contractor generally spends performing such services and time, wage or payment records for the employee/contractor to satisfy the record keeping requirement. 

Since an owner’s time must still be kept contemporaneously in counting towards the 250 hours, any individual owners or individuals who have rental properties under disregarded limited liability companies may wish to change to have the ownership of the rental properties be under an entity taxed as a partnership or an S corporation (S corp), so that the individual can act as an independent contractor/agent of the entity and potentially avoid the contemporaneous records requirement by maintaining the above information.

It’s noteworthy that S corps typically won’t be an appropriate vehicle because employed shareholders are required to be compensated for their time, and wages paid to an employed shareholder are subject to self-employment taxes and don’t qualify for the Section 199A deduction

3. Meeting the 250-hour Safe Harbor for at least three out of the last five years will be sufficient, if the leasing business is at least four years old.  This replaces the provision from the Notice that indicated that the three-out-of-the-last-five rule would only apply for tax years beginning after Dec. 31, 2022.

4. The Safe Harbor continues to allow taxpayers to combine multiple properties held directly, or through disregarded entities, together as one real estate enterprise.  Partnerships and S corps may also combine properties held directly, or through disregarded entities, as one real estate enterprise, however similar properties held under different partnerships or S corps may not be combined, even if common ownership exists.  If time spent on the real estate enterprise is at least 250 hours each year, or in three out of the last five years, then the real estate enterprise will be considered a trade or business.  Once the election is made to combine properties as a single real estate enterprise, all similar properties must be combined as a single real estate enterprise in future tax years if the Safe Harbor is used.

5. Commercial and residential real estate can still not be combined.  Both the Notice Rev. Proc. 2019-38 indicate that taxpayers can combine all of their time spent on commercial properties held directly, or through disregarded entities, under one grouping and all of their time spent on residential properties held directly, or though disregarded entities, under another grouping for purposes of enhancing the ability to characterize multiple properties as being an active trade or business.  Partnerships and S corps may also combine similar use properties that are held directly by the partnership or S corp or through disregarded entities wholly owned by the partnership or S corp. 

Rev. Proc. 2019-38 added a new section that specifically recognizes that time spent on a property that integrated commercial and residential uses won’t need to be separated into commercial time and residential time and can be combined together for purposes of the safe harbor.  The residential/commercial mixed-use property can’t be combined with purely commercial properties, purely residential properties or other mixed-use properties. Therefore, owners holding mixed-use property must independently meet the Safe Harbor for each mixed-use property. 

6. Rev. Proc. 2019-38 generally maintains the same lists of activities that will and won’t count towards the 250 hours.

The only significant change was that the reference to time spent planning, managing or constructing long-term capital improvements now refers to time spent improving property under Treasury Regulations Section 1.263(a)-3(d), which doesn’t count towards the 250-hour requirement. Treas. Regs. Section 1.263(a)-3(d) provides 68 examples as to what is and what isn’t considered “improving property” and provides much better guidance for taxpayers. 

The specific items that are counted towards time spent, which may be performed by owners or employees, agents or independent contractors of the owners, are:

(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, including the purchase of materials and supplies;

(vi)      management of the real estate; and

(vii)     supervision of employees and independent contractors. 

The specific items that aren’t counted towards time spent are: