We have previously considered the “trade or business” requirement for the Section 199a deduction. The government recently issued guidance to clarify when rental real estate activities can qualify for the deduction. While the guidance is needed, it adopts a record keeping requirement that effectively prevents most rental real estate activities from ever qualifying for the safe harbor.
About the Sec. 199a Business Income Deduction
Section 199a was added to the Code as part of the Tax Cuts & Jobs Act in late 2017 and effective January of 2018. It provides a deduction in the amount of 20% of qualified business income.
There are nuances as to what counts as to qualified business income, but one such qualification is that the income has to be from a trade or business. As we noted in our prior article, there is a question whether rental activities rise to the level of being a trade or business.
Since our last article, the government released proposed and now final regulations that clarify that real estate can be a trade or business. The regulations adopted the standard from Section 162 for ordinary and necessary business expenses.
Concurrent with the final regulations, the IRS released guidance that provided a safe harbor for certain real estate activities. Taxpayers are to take advantage of this safe harbor by including a statement with their tax return. The statement is used to confirm that the taxpayer (by their own efforts or those of their agents) qualified for the safe harbor.
There have been quite a few articles that cover the nuances of the safe harbor. We won’t address those topics. Since we focus on IRS disputes, we’ll address the record keeping requirement to qualify for the safe harbor.
Record Keeping Requirement for the Safe Harbor
To qualify for the Sec. 199a real estate activity safe harbor, the IRS guidance identifies the following records that must be kept:
(A) Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise. If a rental real estate enterprise contains more than one property, this requirement may be satisfied if income and expense information statements for each property are maintained and then consolidated;
(B) For rental real estate enterprises that have been in existence less than four years, 250 or more hours of rental services are performed (as described in this revenue procedure) per year with respect to the rental real estate enterprise. For rental real estate enterprises that have been in existence for at least four years, in any three of the five consecutive taxable years that end with the taxable year, 250 or more hours of rental services are performed (as described in this revenue procedure) per year with respect to the rental real estate enterprise; and
(C) The taxpayer maintains 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. If services with respect to the rental real estate enterprise are performed by employees or independent contractors, the taxpayer may provide a description of the rental services performed by such employee or independent contractor, the amount of time such employee or independent contractor generally spends performing such services for the enterprise, and time, wage, or payment records for such employee or independent contractor. Such records are to be made available for inspection at the request of the IRS.
Let’s go through these record keeping requirements one-by-one.
Separate Books & Records
The Sec. 199a rules present a few tax planning opportunities for real estate owners. For example, they may benefit from grouping their real estate strategically to take advantage of the income properties that are cash flow positive, while excluding the properties with losses. This may help maximize the Sec. 199a deduction.
This tax planning requires “books and records” be kept. By keeping records, or by strategically not keeping records, taxpayers may be able to accomplish this goal.
But what exactly is a “book and record?” It is not defined in the guidance. One is left wondering whether an accounting record created by the tax return preparer for this very purpose is sufficient? Put another way, is a tax motivated record sufficient? If it is, is the absence of such a record also determinative for properties the taxpayer would prefer to keep out of the safe harbor and out of the Sec. 199a calculation?
250 Plus Rental Service Hours
The 250 plus rental service hours also raises a number of questions. These 250 plus rental service hours rules count the following activities:
(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 rules go on to exclude several investment activities, such as financial or investment management activities, such as arranging financing; procuring property; studying and reviewing financial statements or reports on operations; improving property; and hours spent traveling to and from the real estate.
These rules are very similar to the material participation rules. Like the material participation rules, the taxpayer has to track their time. They have to track their time by activity. And they have to keep a record of their time and activity for several years.
The “contemporaneous records” requirement might also look familiar. It is similar to the mileage expense rules in Sec. 274.
The mileage rules require a taxpayer to keep a mileage log, state the to and from address, the reason for the trip, etc. Compare that to this requirement that the taxpayer keep records showing (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.
How Safe is the Safe Harbor?
The safe harbor is problematic. It creates a documentation standard that goes well beyond any documentation standard found in our tax laws. It creates a standard that very few taxpayers could ever satisfy. And it creates a situation where the IRS is likely to challenge records the taxpayer did keep. The stakes are high enough for this type of challenge by the IRS, as the Sec. 199a deduction is substantial.
The IRS’s treatment of the material participation and mileage rules provide some insight as to how IRS agents might handle this safe harbor. IRS agents almost always challenge the substantiation kept when either of these issues come up during an IRS audit.
For the material participation rules and the mileage rules, a cynic might even say that the general rule is that there is and can be no records that are sufficient to meet either of these tests to the IRS’s satisfaction. The same cynic might even say that given this high hurdle for the safe harbor, there really is no safe harbor. Those taking the deduction for rental real estate should consider whether they qualify for the deduction and the risks involved before taking the deduction.