The §199A Final Regulations were released on January 18, 2019 and a corrected version was issued on February 1, 2019, with a few corrections and clarifications.
In order for a real estate rental activity, or any activity for that matter, to qualify for the §199A deduction it must constitute a trade or business for tax purposes. In that regard, the Final Regulations will in some respects be disappointing to the real estate rental industry.
Related Party Lease Safe Harbor. It is common in closely held businesses that real property is held in one entity and leased to another controlled entity. Fortunately, the Final Regulations keep the favorable related party rental trade or business safe harbor for purposes of §199A. Under this safe harbor, property leased to a related party trade or business, including under a triple net lease, will be deemed to be part of a trade or business even if such property would not otherwise meet the trade or business test under case law interpreting the requirements of §162. The Final Regulations abandoned the related party rule of the Proposed Regulations and instead adopted the more expansive related party rules of §267(b) and 707(b), which include siblings, spouses and lineal descendants, as well as parents. The Final Regulations clarify that the related parties must be individuals or passthrough entities. Unfortunately, triple net leases to unrelated lessees do not qualify for this trade or business safe harbor.
Real Estate Rental Trade or Business Safe Harbor. Rental properties which don’t qualify for the related party lease safe harbor may qualify for a separate trade or business safe harbor provided by Notice 2019-07, which was released in conjunction with the Final Regulations. The issue of when real estate rental activities constitute a trade or business, particularly in the case of triple net leases, has continued to be a problem for holders of rental real estate and the clarity of a safe harbor was needed. However, on closer inspection, the safe harbor offered by Notice 2019-07 appears to be largely a mirage for many rental property owners. In order to satisfy the safe harbor the following requirements must be satisfied with respect to a “real estate rental enterprise” (defined below):
- At least 250 hours of rental services must be performed each year, whether by the owner, employees or independent contractors, with respect to the real estate rental enterprise, on maintenance, repairs, collection of rent, payment of expenses, provision of services to tenants and efforts to rent the property;
- However, activities as an investor, including arranging financing, procuring property, reviewing financial statements or reports on operations, planning, managing or constructing long-term capital improvements, and traveling to and from the real estate are not considered hours of service with respect to the real rental enterprise and therefore do not count;
- Separate books and records and separate bank accounts must be maintained for the real estate rental enterprise; contemporaneous records must be kept, including time reports or similar records for (a) hours of services performed; (b) descriptions of the services performed; (c) dates such services were performed, and (d) a description of the services performed; and
- Most significantly, property under a triple net lease or used by the taxpayer as a personal residence for more than 14 days during the taxable year do not qualify for the safe harbor.
A triple net lease is defined in the Notice as one that requires the tenant or lessee pay taxes, fees, and insurance, and to be responsible for maintenance in addition to rent and utilities, including lease agreements which require the tenant to pay common area maintenance expenses, wherein the tenant pays its allocable portion of the property’s taxes, fees, insurance, and maintenance activities which are normally paid by the landlord. A taxpayer who leases rental property to tenants on such a triple net lease may have to modify the nature of the expense obligations under the lease if they want to qualify the property for the §199A deduction.
The 250 hour threshold seems a bit high for many real estate rental enterprises to satisfy. To constitute a single “real estate rental enterprise” for purposes of the 250 hour requirement the rental properties must be held by an individual or a single passthrough either directly or through a disregarded entity. This may take the form of a single partnership which owns a separate disregarded single member LLC for each rental property. A taxpayer may combine the time spent on all of the rental properties so comprising a single real estate rental enterprise in determining compliance with the annual 250 hour threshold.
Conversely, rental properties held in separate partnerships for tax purposes (including separate LLCs taxed as partnerships) constitute separate enterprises and must each independently satisfy the 250 hour requirement. Furthermore, commercial and residential properties are not permitted to be included in the same real estate rental enterprise. Therefore, the 250 hour test will have to be satisfied separately as to each such property type. Again, taxpayers may have to do some restructuring of their current ownership of real estate rental properties in order to take advantage of the safe harbor. In the case of a taxpayer with ownership of rental properties across multiple partnerships that restructuring may take the form of dropping each partnership’s rental properties into separate single member LLCs and then merging the partnerships together. Of course other non-tax considerations may also factor into that restructuring decision.
If the real estate rental enterprise meets the 250 hour test, it likely would qualify for trade or business status under prevailing case law anyway, in which case the safe harbor may only provide a greater degree of certainty for the taxpayer. On the other hand, with the exception of triple net leases to a related lessee, it appears that most triple net leases will continue to be left out of the §199A benefits.
It should be noted that failure to meet the safe harbor requirements does not preclude a taxpayer from attempting to make a case that it satisfies the trade or business requirements under the case law interpreting §162. The Supreme Court noted in Commissioner v. Groetzinger, 480 U.S. 23 (1987) that for purposes of establishing a trade or business the taxpayer must be engaged in an activity with continuity and regularity, for which a primary purpose is earning income for profit. Some taxpayers may be able to qualify a triple net lease activity as a trade or business to the extent it engages in substantial lease negotiations. Short term triple net leases may in some instances provide potential for establishing regular and continuous lease negotiation activities. Long term triple net leases will be problematic.
Like-Kind Exchanges. The amount of the §199A deduction may in some cases be increased to the extent the taxpayer has an unadjusted basis immediately after acquisition (“UBIA”) in qualified property, including depreciable real property. The Final Regulations provide much more taxpayer-friendly rules for the determination of UBIA in like-kind exchanges. In general, the UBIA of replacement property will be based on the taxpayer’s unadjusted basis in the relinquished property (i.e. the taxpayer’s basis in the relinquished property without reduction for depreciation or other adjustments). That basis is increased for any net boot paid by the taxpayer in addition to the relinquished property and is decreased for any net boot received in the exchange. Such boot includes any property transferred or received which is not like-kind. Any increase in UBIA for money or non like-kind property transferred by the taxpayer will be treated as a separate property placed in service when the replacement property is placed in service.
Aggregation of Real Estate Rental Properties. The Final Regulations retain, with some modifications, the aggregation rules introduced by the Proposed Regulations. These rules permit taxpayers to aggregate their interests in separate trades or businesses in applying the requirements for the §199A deduction. This can be beneficial in cases where, for instance, one of the taxpayer’s businesses has excess qualified business income and another has excess W-2 wages and/or qualified property. However, problems continue to persist for some real estate aggregations, as more fully discussed in a separate blog post “Section 199A Final Regulations Issued on Eve of the 2018 Filing Season.”
The Final Regulations bring welcome clarity for real estate like-kind exchanges but also fail to provide the type of taxpayer-friendly rental real estate safe harbors and clarity that many taxpayers had requested, particularly with respect to the trade or business status of triple net leases to unrelated lessees.
For questions regarding the §199A deduction or the Final Regulations, please contact Tom Hineman at 214-744-3700.
 For taxable years beginning after 2022 the 250 hour test must be met in at least three out of five taxable years ending with the taxable year at issue.