The Tax Cuts and Jobs Act of 2017 (TCJA) made sweeping changes to business income taxation. In the year since enactment, the Internal Revenue Service and Treasury have provided guidance in many areas, some of which require further clarification. However, there are still many sections of the law on which they have been silent. This has created many challenges for businesses and tax professionals in addressing particular tax return issues.
The most common form of ownership of real estate is as a pass-through entity, typically a Limited Liability Company (LLC) or a Limited Partnership (LP). The TCJA created the widely discussed Internal Revenue Code Section 199A, Qualified Business Income Deduction.
For commercial real estate, the threshold to be able to receive the benefit of the 20% Qualified Business Income (QBI) deduction is that the activity must constitute a trade or business. The basic definition used for a trade or business under the proposed and final regulations is a trade or business under Internal Revenue Code section 162, other than the trade or business of performing services as an employee.
In most non-real estate circumstances, it will be clear whether the activity being considered is a trade or business (e.g., attorney’s office, retail store, and manufacturer). However, the issue is less certain when it comes to real estate rental activities. This was a significant issue raised at the hearing on the proposed regulations held in October 2018. The real estate industry requested a safe harbor as well as other guidance.
The IRS issued a notice that proposes a safe harbor under which certain real estate enterprises will be treated as a trade or business under IRC section 199A. The Service notes that failure to satisfy this safe harbor does not prevent the taxpayer from establishing, under other tax analysis, that the real estate activity constitutes a trade or business.
For purposes of the safe harbor, a “rental real estate enterprise” is defined as an interest in real property held for the production of rents. This may consist of an interest in multiple properties which can be aggregated for applying this safe harbor. However, the individual or entity relying on this safe harbor must hold the interest directly or through a disregarded entity. This means that properties held in different LLCs taxed as partnerships, or through separate S corporations, cannot be aggregated for this safe harbor rule.
Additionally, commercial rental properties cannot be combined with residential properties.
The safe harbor permits treatment of the tested real estate (or combined real estate activities) as a trade or business where:
- Separate books and records are maintained to reflect the income and expenses of each rental real estate enterprise (or combined real estate enterprises);
- For tax years beginning before January 1, 2023, 250 or more hours of “rental services” are performed per year with respect to the rental real estate enterprise. For tax years beginning after December 31, 2022, 250 hours or more of “rental services” must be performed per year in any three of the five consecutive tax years ending in the current tax year. If the enterprise was held for less than five years, then this latter test is satisfied by 250 hours or more of “rental services” with respect to the rental real estate enterprise; and
- The taxpayer must maintain a contemporaneous record (including time reports, logs or similar documents), regarding: (i) hours of all services performed; (ii) description of the services performed; (iii) dates on which such services were performed; and (iv) who performed the services. However, this contemporaneous records requirement will not apply to taxable years beginning prior to January 1, 2020.
- If a taxpayer is taking the position that a rental activity is a trade or business for section 199A purposes, there will be a requirement to file Form 1099 where applicable.
For purposes of the safe harbor, “Rental Services” include: (i) advertising to rent or lease the real estate; (ii) negotiating and executing leases; (iii) verifying information in prospective tenant applications; (iv) collection of rent; (v) daily operations, maintenance and repair of property; (vi) management of the real estate; (vii) purchase of materials; and (viii) supervision of employees and independent contractors. The rental services can be performed by owners or by employees, agents and/or independent contractors.
The major problem with utilizing the safe harbor is that certain real estate operations are excluded:
- Property used as a residence for any part of the year under IRC sec 280A (e.g., more than 14 days for the year) is not eligible for the safe harbor.
- Real estate rented or leased under a “triple net lease” is excluded. This includes a lease agreement requiring the tenant or lessee to pay taxes, fees and insurance and to be responsible for the maintenance activities in addition to rent and utilities. It also 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. This would include many commercial leases.
It is important to reiterate that although a “triple net lease” property is ineligible for the safe harbor, not having the safe harbor election does not bar the taxpayer from utilizing the benefit of the 199A deduction.
Anyone using the safe harbor is required to attach a statement to the return, subject to penalty of perjury, that these requirements have been satisfied.
The final regulations maintain the special rule for commonly controlled entities, which provides that the rental of real estate to a commonly controlled entity (based on 50% or more common ownership) is automatically deemed to be a trade or business (so there is no reason to satisfy either the safe harbor or the section 162 standard). However, unlike the proposed regulations, the final regulations use attribution rules to determine constructive ownership.
While there has been focus on many aspects of the TCJA, the interest expense limitation under IRC Section 163(j) may have the most effect on the real estate industry. More than any other new or changed code section. In many ways, the leasing of real estate is simply off-balance sheet financing for many companies. The multi-family market is an “off-balance” sheet approach to an individual’s shelter, rather than having to use one’s own balance sheet to own a home. Leverage is very common to real estate companies, and this leverage was under attack by the TCJA. IRC Section 163(j) limited the interest expense deduction for business interest expense (“BIE”) to the extent of the sum of the following:
- 30% of adjusted taxable income (‘ATI)
- 100% of business interest income (“BII’)
- 100% of the taxpayer’s floor plan interest.
There were two major exemptions to the disallowed BIE; one was for small businesses under $25 million and the other was for Electing Real Property Trade or Business companies. At first glance, it would seem that most real estate entities would be covered by the $25 million exemption, and they could deduct all of their interest expense. However, the $25million exemption has two catches. First are the complex series of aggregation rules that require entities with common ownership to aggregate their receipts.
The second hurdle in the $25 million gross receipts exemption is that it does not apply to tax shelters. In general, the term “tax shelter” includes:
- Any enterprise, other than a C corporation, if at any time interest in such enterprise has been offered for sale in any offering required to be registered with any federal or state agency having the authority to regulate the offering of securities for sale.
- Any syndicate (within the meaning of certain Internal Revenue Code sections); a partnership or S corporation in which more than 35% of the losses of such entity during the taxable year are allocable to limited partners or limited entrepreneurs.
Any tax shelter is defined as any partnership or other entity, or any plan or arrangement, if a “significant purpose” of such partnership, entity, plan or arrangement is the avoidance or evasion of federal income tax. This is also potentially problematic, but we would hope it does not apply merely because the taxpayers chose to organize an entity as a flow-through entity rather than a C corporation, assuming the business was formed to make an economic profit and not to create inflated tax losses.
Thus, if a real estate entity had losses allocated to its limited partners and was deemed to be a tax shelter, the entity had one final solution to having its BIE not limited. The entity can be an Electing Real Property Trade or Business. This is applicable to any taxpayer who is engaged in a “real property trade or business” (RPTB), who may file an irrevocable election to not be subject to the section 163(j) limitation.
For assistance in your tax preparation for 2019 and tax planning for 2020, contact Grant Thornton Israel’s US Tax practice.