“A ship in harbor is safe, but that is not what ships are built for.” — John A. Shedd, 1928
One underreported codicil of 2017’s Tax Cuts and Jobs Act is a 20% pass-through deduction under its section 199A. How a business might qualify for this exemption off a business’s net profit, though, was not clearly defined when the law passed. Clarity came this past September, when the Internal Revenue Service offered its guidance, including a safe harbor provision for rental properties.
The knock on the 2017 tax reform package has been, with some justification, that it benefits corporate businesses greatly but not so much individual taxpayers. What, then is the effect of this particular rule on the closely held firm? And, from Sharestates investors’ perspective, how might it benefit the commercial real estate industry? After all, it’s a general provision, not specific to building and operating rental properties.
Let’s start by defining our terms. It’s not safe to assume that we all have the same understanding of what’s meant by “safe harbor,” so maybe that should be our jumping-off point.
A safe harbor is a provision in law or regulation that specifies actions that are deemed not to violate a given rule, typically one that was vaguely worded. For example, it can help define was does or doesn’t constitute “recklessness,” as in reckless driving or reckless endangerment.
This applies to the Tax Cuts and Jobs Act because its definition of “qualified business income” is comprised in part by the taxpayer’s receipts from a “trade or business”. While the 2017 tax law includes REIT dividends in the definition, it remained silent on the treatment of real estate rental income not connected to these trusts. And, while the term “qualified trade or business” was defined under the statute, it remained unclear if real estate management services were included. The fact that engineering, architecture and investment management services were singled out as specifically not qualified had many real estate investors anxious.
Some case law, though, was on the investors’ side.
“In general, courts have held that in order for a taxpayer’s activity to rise to the level of constituting a trade or business, the taxpayer must satisfy two requirements: (1) regular and continuous conduct of the activity, which depends on the extent of the taxpayer’s activities; and (2) a primary purpose to earn a profit, which depends on the taxpayer’s state of mind and their having a good faith intention to make a profit from the activity,” according to lawyer Lou Vlahos of Long Island-based Farrell Fritz. “In most situations, neither the taxpayer nor the IRS should find it difficult to evaluate the trade or business status of the taxpayer’s activities – the level and quality of the activity will be such that its status will be obvious. Unfortunately, there remain a number of cases in which the various ‘triers of fact’ – first, the taxpayer, then the IRS, and finally the courts – will have to consider the taxpayer’s unique ‘facts and circumstances’ in determining whether the taxpayer’s activities rise to the level of a trade or business.”
Guidance offered in September 2019, though, clarified that the 199A treatment indeed extends a safe harbor provision for some, but not all, interests in rental real estate, enabling them to be treated as a “trade or business”.
It’s mainly a matter of threshold and, if all the requirements are met, an interest in rental real estate can be treated as a single trade or business for purposes of the section 199A deduction. But even if such an interest fails to satisfy all requirements, it might still be extended treatment as a trade or business for 199A purposes if it otherwise meets the definition of a trade or business in the regulation.
A rental real estate enterprise under the IRS definition “may consist of an interest in a single property or interests in multiple properties,” according to the IRS. “The taxpayer or a relevant passthrough entity (RPE) relying on this revenue procedure must hold each interest directly or through an entity disregarded as an entity separate from its owner, such as a limited liability company with a single member.”
Who’s in, who’s out
The following requirements must be met by taxpayers or RPEs to qualify for this safe harbor, according to IRS guidance:
- separate books and records for each enterprise;
- 250 or more hours of rental services are performed in at least three of the past five years, or in every year of its existence for enterprises less than four years old;
- the taxpayer maintains contemporaneous records of hours, dates and descriptions of all services performed, as well as who performed the services; and
- the taxpayer or RPE attaches a statement to the return filed for tax years the safe harbor is relied upon.
If it were that simple, though, it would be off-brand for the IRS. Audit firm CliftonLarsonAllen clarifies that the following activities do not constitute rental services for purposes of 199A qualification:
- financial or investment management services;
- arranging financing;
- procuring property;
- studying or reviewing financial statements or operating reports;
- planning, managing, or constructing long-term capital improvements; or
- time spent traveling to and from real estate.
In other words, you’d have to confine the definition of rental services to the mule work of advertising, negotiating, verifying applications, collecting rent, purchasing, staff supervision and other elements of daily operations.
Further, CLA clarifies that vacation homes, triple net leases and self-rentals are ineligible for the safe harbor.
When ‘no’ doesn’t mean ‘no’
Thus, many enterprises still wouldn’t meet the safe harbor requirements, at least not automatically. The threshold is fairly arbitrary, after all. It’s puzzling why triple net leases — in which the tenant is responsible for taxes, maintenance and insurance — are excluded. And what’s magical about contributing 250 hours to the upkeep of the property if the work could be done in 249?
CLA’s Ben Darwin and John Werlhof offer workarounds for enterprises that don’t quite qualify. First, if the hurdle is the self-rental rental rule, there are ways a rental enterprise could be considered a trade or business if the tenant is commonly owned and generates QBI.
“Consider whether the rental rises to the level of a business based on the relevant facts,” they advise. These include the type of rented property (commercial real property versus residential property, number of properties rented, owner’s or the owner’s agents’ day-to-day involvement, types and significance of any ancillary services provided under the lease and terms of the lease.
“In some cases, it may be preferable to avoid business status (e.g., where the rentals generate a loss that would reduce the 20% QBID). You may want to evaluate whether the business classification of your rentals is actually better,” according to the CLA authors. “Consider whether any changes can be made to your lease arrangements and rental operations to obtain more favorable tax treatment.”
Just because you can do a thing doesn’t mean you ought to. And just because your real estate enterprise qualifies for the safe harbor doesn’t mean you should drop anchor in it.
“If you have rental losses, you DO NOT want your enterprise to be considered QBI and included in the 199A Deduction calculation, BUT you (or your spouse) DO want to be considered a real estate professional in order to deduct the losses against your other ordinary income,” according to the blog of tax lawyer and capitalization fiend Mark J. Kohler. “If you have net rental income, you DO want the enterprise to be considered QBI in order to receive the 199A Deduction, but still consider the income passive and not subject to self-employment tax.”
In many if not most cases, though, investors have been handed a 20% rebate on the tax bills for their real estate cash flows. But there’s no end to the flexibility in the tax code, so it’s best to consult a good accountant — or you might need to consult an even better lawyer.