On January 18, 2019, the United States Department of the Treasury (“Treasury”) and the Internal Revenue Service (“IRS”) released several items of additional guidance regarding Section 199A of the Internal Revenue Code (“IRC” or the “Code”). The guidance included Notice 2019-07, which provides a proposed revenue procedure that sets forth a safe harbor under which a rental real estate enterprise will be treated as trade or business for purposes of Section 199A, and Final Treasury Regulations (“Final Regulations”) (RIN 1545-BO71), which include updated guidance as to the treatment of qualified property received in a 1031 like-kind exchange and a step-up in basis for acquired partnership interests under Section 743(b) for purposes of applying a limitation under Section 199A. This tax alert provides an overview of these critical issues for the real estate industry.
Overview Newly Released Guidance
As part of the Tax Cuts and Jobs Act of 2017 (“TCJA”), Congress enacted IRC Section 199A which provides a new 20% deduction for owners of pass-through entities, including sole proprietorships, disregarded entities, partnerships, S-corporations, and trusts. The deduction was provided as a counter-balance to the new 21% tax rate available to C-corporations. For owners of pass-through entities taxed at the highest individual marginal tax rate of 37%, the deduction can decrease the 37% tax rate to 29.6%.
On January 18th, Treasury and the IRS released four items of guidance regarding Section 199A:
- Final Regulations (RIN 1545-BO71) regarding several aspects of the new tax provision, including determination of a trade or business, calculation of Qualified Business Income (“QBI”), the ability to aggregate trades or businesses for purposes of the deduction, and definitions of Specified Service Trades or Businesses (“SSTB”);
- Proposed Regulations (REG-134652-18) regarding treatment of previously suspended losses for purposes of calculating QBI, as well as the determination of the deduction for taxpayers that hold interests in regulated investment companies, charitable remainder trusts, and split-interest trusts;
- Revenue Procedure 2019-11 governing the calculation of the W-2 wage limitation for purposes of the deduction; and
- Notice 2019-07 providing a proposed revenue procedure that provides for a safe harbor under which a rental real estate enterprise will be treated as trade or business for purposes of the deduction.
New Safe Harbor for Rental Real Estate Enterprises
Section 199A(d) defines a qualified trade or business as any trade or business other than an SSTB or the trade or business of performing services as an employee. Final Regulation §1.199A-1(b)(14) defines trade or business, in pertinent part, as a trade or business under Section 162 other than the trade or business of performing services as an employee. Due to uncertainty as to whether a rental real estate enterprise constitutes a trade or business for purposes of Section 199A, Treasury and the IRS released Notice 2019-07, which provides a proposed revenue procedure for a safe harbor under which a rental real estate enterprise will be treated as a trade or business solely for purposes of Section 199A.
Rental Real Estate Enterprise Defined
The proposed revenue procedure defines a “rental real estate enterprise” as “an interest in real property held for the production of rents and may consist of an interest in multiple properties.” An individual or relevant passthrough entity (“RPE”) must hold the interest directly or indirectly through a disregarded entity.
As set forth in the proposed revenue procedure, a taxpayer that seeks to rely on the safe harbor must either treat each property held for the production of rents as a separate enterprise or treat all similar properties held for the production of rents as a single enterprise. However, commercial and residential real estate may not be part of the same enterprise; and taxpayers may not vary the treatment from year-to-year unless a significant change in facts and circumstances exists.
Rental Activities Excluded from the Safe Harbor
The proposed revenue procedure provides that real estate used by a taxpayer, including an owner or a beneficiary of an RPE, as a residence for any part of the year under Section 280A, is not eligible for the safe harbor. Additionally, the proposed revenue procedure sets forth that real estate rented or leased under a triple net lease is not eligible for the safe harbor. For purposes of the proposed revenue procedure, a triple net lease includes a lease agreement that requires the tenant or lessee to pay taxes, fees, and insurance, and to be responsible for the maintenance of the property, as well as the rent and utilities. The proposed revenue procedure notes that this includes a lease agreement that requires the tenant or lessee to pay a portion of the taxes, fees, and insurance, and to be responsible for maintenance activities allocable to the portion of the property rented by the tenant.
Importantly, taxpayers with such rental property arrangements may still be eligible for the Section 199A deduction. However, rather than relying on the safe harbor to establish the rental activities as a qualified trade or business, such taxpayers will have to rely on existing law to establish that they meet the definition of a trade or business under Final Regulation §1.199A-1(b)(14).
Elements of the Safe Harbor
The safe harbor set forth in the proposed revenue procedure consists of three requirements that a rental real estate enterprise must meet to be considered a qualified trade or business solely for Section 199A:
- Maintain separate books and records to reflect income and expenses;
- For taxable years beginning prior to January 1, 2023, 250 or more hours of rental services are performed per year with respect to the rental enterprise. For taxable years beginning after December 31, 2022, in any three of the five consecutive taxable years that end with the tax year (or in each year for an enterprise held for less than five tax years), 250 or more hours of rental services are performed per year with respect to the rental real estate enterprise; and
- Taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, regarding hours of services performed, description of such services, dates on which such services are performed, and identification of who performed such services. The records must be made available for inspection at the request of the IRS.
The contemporaneous records requirement does not apply to taxable years beginning prior to January 1, 2019.
Breaking Down Rental Activities
The proposed revenue procedure clarifies that the following activities constitute rental activities for purposes of the safe harbor:
- Advertising to rent or lease the real estate;
- Negotiating and executing leases;
- Verifying information contained in prospective tenant applications;
- Collection of rent;
- Daly operation, maintenance, and repair of the property;
- Management of the real estate;
- Purchase of materials; and
- Supervision of employees and independent contractors.
The proposed revenue procedure further states that rental services do not include the following:
- Financial or investment management activities, such as:
- Arranging financing;
- Procuring property;
- Studying and reviewing financial statements; or
- Reports on operations;
- Planning, managing, or constructing long-term capital improvements; or
- Hours spent traveling to and from the real estate.
Finally, the proposed revenue procedure states that the rental activities may be performed by owners, employees, agents, or independent contractors of the owners. Therefore, several parties’ activities may be aggregated for purposes of meeting the 250 hours requirement.
Procedural Requirements for Applications of the Safe Harbor
The proposed revenue procedure sets forth that a taxpayer or RPE that relies on the safe harbor must include a statement attached to the applicable tax return on which it either claims the Section 199A deduction (Form 1040) or passes through Section 199A information (Schedule K-1) that the requirements of the safe harbor have been satisfied. The statement must be signed by the taxpayer, or any authorized representative of an eligible taxpayer or RPE. The signer of the statement must have personal knowledge of the facts and circumstances related to the statement. Treasury and the IRS have requested comments on this portion of the safe harbor.
The proposed revenue procedure applies to taxable years ending after December 31, 2017. Taxpayers may rely on the safe harbor in the proposed revenue procedure until such time it is published in final form. The safe harbor is, by design, restrictive and fails to address many questions concerning when the relevant taxpayers is engaged in a trade or business. It is likely that many real estate professionals will not apply it.
Critical Elements of Final Regulations for Real Estate Professionals
1031 Like-Kind Exchanges
The Final Regulations adopted a significant portion of the Proposed Treasury Regulations (REG-107892-18) released on August 8, 2018. FGMK continues to review the Final Regulations and will provide additional guidance in future Tax Alerts. However, real estate professionals will be happy to know that one critical modification of the proposed regulations adopted in the Final Regulations concerns the determination of the unadjusted basis immediately after acquisition (“UBIA”) of property received in a like-kind exchange under Section 1031.
Under Section 199A, if a taxpayer’s taxable income exceeds a threshold ($157,500 for single taxpayers and $315,000 for married taxpayers filing a joint return for the 2018 tax year), a taxpayer’s deduction may be limited to the extent of 50% of allocated W-2 wages or 25% of allocated W-2 wages, plus 2.5% of allocated UBIA. The latter limitation calculation was provided with the real estate industry in mind due to the limited amount of wages in certain real estate entities.
For purposes of Section 199A, UBIA equals the basis of qualified property, as determined immediately after acquisition of such property. Section 199A(b)(6)(A) defines “qualified property” as tangible property of a character subject to the allowance for depreciation under Section 167 which is held by, and available for use in, the qualified trade or business at the close of the tax year, which is used at any point during the tax year in the production of qualified business income, and the depreciable period for which has not ended before the end of the tax year.
Section 199A(b)(6)(B) defines “depreciable period” as beginning on the date the property is first placed in service by the taxpayer and ending on the later of the date that is 10 years after such date or the last day of the last full year in the applicable recovery period that would apply to the property under Section 168. Therefore, if a taxpayer placed a piece of qualified property with a five-year recovery period and $100 costs basis into service on January 1, 2019, the depreciable period would end on January 1, 2029, providing the taxpayer with UBIA of $100 through December 31, 2028, as long as the property continued to produce qualified business income, even though it would be fully depreciated under Sections 167 and 168 by the mid-point of the 2024 tax year.
Proposed Treasury Regulation §1.199A-2(c)(3) provided that UBIA was to be determined without regard to any adjustments described in Section 1016(a)(2) or (3), to adjustments for credits, or any adjustments for any portion of the basis for which taxpayer elected to treat as an expense.
However, Example 2 to proposed regulation §1.199A-2(c)(4) illustrated that the UBIA of qualified property received in a like-kind exchange was the adjusted basis of the relinquished property transferred in the exchange as determined under Section 1031(d), which reflects the adjustment in basis for depreciation deductions previously taken under Section 168. Therefore, if a taxpayer initially purchased property for $100, depreciated the property by $10, and then transferred the property in a like-kind exchange, the UBIA of the qualified property received would equal $90, the adjusted basis of the relinquished property, rather than $100.
Following the publication of the August 8th proposed regulations, the government received several comments that the treatment of the received qualified property in Example 2 to proposed regulation §1.199A-2(c)(4) discouraged like-kind exchanges by providing an incentive to retain property in order to maintain a higher UBIA ($100 in the above example), as opposed to a reduced UBIA of received property ($90 in the above example). In the Final Regulations, the government agreed that application of Section 1031(d) to property received in a like-kind exchange contradicted the rule in proposed §1.199A-2(c)(3).
As a result, the Final Regulations provide in §1.199A-2(c)(3)(ii) that the UBIA of qualified property received in a like-kind exchange is that of the relinquished property. As a result, in the above example, the taxpayer in the like-kind exchange would have UBIA of $100 in the received property.
However, the Final Regulations provide that the UBIA will be decreased by any “boot”, e.g. money, received in the like-kind exchange transaction or increased by the amount of money paid or the fair market value of property not of like-kind to the relinquished property transferred by the taxpayer to acquire the replacement property. For purposes of property received in a like-kind exchange, the like-kind property received will have the same placed-in-serve date as the relinquished property for purposes of the depreciable period. Any increased UBIA will be treated as separate qualified property with a placed-in-service date of the date in which the received property is first placed in service by the taxpayer.
The Final Regulations apply similar treatment to property in Section 1033 involuntary conversion transactions.
Treatment of Basis Step-Up for Acquired Partnership Interest
Under the general principles of Subchapter K, which governs the tax treatment of partnerships, a new partner receives a step-up in its share of the partnership’s property based on an increased fair market value of such property, as reflected in the purchase price of the partnership interest. The basis step-up is provided by Section 743(b). The partnership itself can receive a similar step-up in basis of partnership property in the case of a distribution of property to a partner under Section 734(b).
The August 8th proposed regulations provided that basis adjustments under Sections 734(b) and 743(b) would not be treated as qualified property. Therefore, while a partner who purchases a partnership interest would receive a stepped-up basis under Section 743(b) for other partnership basis purposes, it would not receive UBIA for that stepped-up basis for purposes of Section 199A.
Following issuance of the proposed regulations, Treasury and the IRS received comments that supported application of Sections 734(b) and 743(b) for the purpose of calculating a partner’s UBIA allocation. In the Final Regulations, Treasury and the IRS maintain their position that a Section 734(b) adjustment is not an acquisition of qualified property for purposes of determining UBIA. However, they agree that the acquiring taxpayer’s Section 743(b) basis adjustments should be treated as qualified property to the extent that the Section 743(b) basis reflects no more than the taxpayer’s share of the fair market value of the underling qualified property. As a result, a taxpayer may receive additional UBIA for purposes of the Section 199A deduction limitation calculation.
The safe harbor in the proposed revenue procedure provides some clarity for taxpayers engaged in rental real estate activities. It also provides a potential opportunity for those taxpayers with triple net lease operations to consider alternative structuring of rental or lease agreements in order to avoid exclusion from the safe harbor application. However, taxpayers need to consider all legal and tax implications when analyzing the application of the safe harbor. For example, the Preamble to the Final Regulations advises that a taxpayer report items consistently regarding the application of the Section 162 trade or business standard. Therefore, if a taxpayer contends that a trade or business exists for purposes of Section 199A, it should report as such for elements of the Code. Otherwise, the IRS will consider the facts and circumstances surrounding the different treatment. For example, if a taxpayer who owns a tenancy in common interest in rental property asserts that such ownership interest occurs through a trade or business for purposes of claiming the Section 199A deduction, it should consider that such treatment may lead the IRS to determine a separate taxable entity exists under Treasury Regulation §301.7701(a)(2) and require compliance with the information return requirements as provided under Section 6041.
The Final Regulations treatment of UBIA for property received in Section 1031 like-kind exchanges eliminates a deterrence for such transactions that had existed under the August 8th proposed regulations. In addition, the inclusion of Section 743(b) adjustments for purposes of UBIA treatment also provides a taxpayer favorable development for taxpayers. The results of these modifications in the Final Regulations will provide affected taxpayers with additional UBIA for purposes of the Section 199A limitation.
For additional guidance on Section 199A, please consult your FGMK tax advisor.
Randy Markowitz Perry Weinstein Danny Laughlin
Partner, Tax Partner, Tax Director, Specialty Tax Practice
847.940.3241 847.940.3233 312.638.2916
RMarkowitz@fgmk.com PWeinstein@fgmk.com DLaughlin@fgmk.com