Hearing the word ‘safe’ is certainly comforting. Who doesn’t want to be safe right?
However, understanding how the new safe harbor for Section 199A rental property can work for you is another story.
The new safe harbor is actually one method of finding out whether your rentals qualify for the new 20 percent tax deduction. Another method is finding out whether your rentals qualify as trades or businesses under existing law.
Should you choose to follow the new safe harbor rules and meet the requirements, the IRS will see your rental as a trade or business with net rental profits that are qualified business income (QBI) for the Section 199A tax deduction.
On the other hand, you may not qualify to use the safe harbor. But no need to worry since you can simply use the other method and win your 199A tax deduction with the existing trade or business tax law rules.
Rental Real Estate Enterprise
Under the new Section 199A rental real estate safe harbor, each rental real estate properties, whether individually or as a group, falls into one of the following categories:
- Residential real estate enterprise
- Commercial real estate enterprise
- Triple net lease real estate
In grouping your properties, you or your pass-through entity should either treat each rental property as a separate enterprise or treat all similar properties as a single enterprise.
For instance, residential rental properties can all be grouped as one enterprise while multiple commercial rentals can be treated as separate enterprises.
Under the safe harbor, you may not vary your enterprise treatment from year to year unless you have a significant change in circumstances.
Safe Harbor Requirements
For Section 199A, the IRS treats rental real estate enterprise as a trade or business if you or your pass-through entity can meet the following:
- You maintain separate books and records that reflect the income and expenses of each rental real estate enterprise.
- You perform 250 or more hours of “rental services” during the tax year.
- You 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. (Important note: The contemporaneous records rule does not apply to tax years beginning before January 1, 2019.)
Rental Services
The qualifying “rental services” can be done by you, your employees, your agents, and/or your independent contractors. These services include:
- advertising to rent or lease the real estate;
- negotiating and executing leases;
- verifying the information contained in prospective tenant applications;
- collecting rent;
- maintaining, repairing, and daily operation of the property;
- managing the real estate;
- purchasing materials; and
- supervising employees and independent contractors.
The following rental services do not qualify for the safe harbor.
- financial or investment management activities, such as arranging financing, procuring property, or studying and reviewing financial statements or reports on operations;
- planning, managing, or constructing long-term capital improvements; and
- hours spent traveling to and from the real estate.
Helpful tip: The most important record for obtaining hassle-free tax deductions on your rental real estate is an accurate and provable time log. If you are using the new Section 199A safe harbor, tracking time spent is essential.
Non-qualifying Real Estate
Triple net lease property does not qualify for the safe harbor. However, you should remember that the safe harbor is not the only method you can use to qualify your rental real estate for the Section 199A tax deduction.
Furthermore, the safe harbor may not be used on real estate that you use as a residence. For a vacation home, Section 280A makes that home either a rental property or a residence.
Tax Return Disclosure
When filing your tax return, you or your pass-through entity must attach a statement saying that you are using the safe harbor and you satisfied the requirements set forth in Section 3.03 of Rev. Proc. 2019-XX.
You or your authorized representative must be knowledgeable of the facts and circumstances required by the statement above and then assert to the IRS that you have this knowledge with the following declaration:
Under penalties of perjury, I (we) declare that I (we) have examined the statement, and, to the best of my (our) knowledge and belief, the statement contains all the relevant facts relating to the revenue procedure, and such facts are true, correct, and complete.
Trade or Business and the Safe Harbor
Overall, getting to the safe harbor may not be easy. Though, once you are inside the safe harbor, you are sure that your rental properties are business properties that can have the possible 20 percent tax deduction under Section 199A.
If you don’t qualify for the safe harbor, the preamble to the IRS’s new final regulations on Section 199A includes the following statement on rental real estate:
‘Providing bright-line rules on whether a rental real estate activity is a section 162 trade or business for purposes of section 199A is beyond the scope of these regulations.’
This shows that if you don’t want to use the safe harbor, you may use the existing tax law rules on identifying trade or business.