The IRS this week released final guidance regarding a safe harbor to help owners of real estate enterprises determine whether they qualify for the new 20% deduction for “qualified business income.” While the safe harbor is largely unchanged in most aspects, it does ease the requirements for owners of mixed-use real estate (commercial and residential in one property) to qualify for the deduction.
For most owners of real property, one of the most positive changes from the Tax Cuts and Jobs Act of 2017 was the new 20% deduction for pass-through businesses and sole proprietors. However, from the enactment of the new law, the availability of the deduction for real estate has been in question.
In January, the Treasury and IRS issued a proposed safe harbor for owners of real estate businesses to more easily determine if they can qualify for the deduction. The issue is that any qualifying enterprise must be considered a “trade or business” under IRS regulations and the applicability of this standard to real estate has been historically unclear. ”Triple-net” leases, for example, have not met the standard in many rulings.
The safe harbor was designed to make it much easier for real estate owners to determine if they indeed meet the “trade or business” standard and can thus claim the deduction.
The proposed safe harbor was generally well received by real estate owners and their tax advisors, but there were some complaints to the IRS that the rules could be made even friendlier. One problem was that the safe harbor did not allow residential and commercial properties to be combined for purposes of meeting the tests, the most significant of which requires 250 hours of rental activities to be performed each year.
The recent release of Revenue Procedure 2019-38 finalizes the safe harbor. Specifically, the new guidance allows mixed-used property to be treated as a single real estate enterprise. However, under the clarification, mixed-use property still cannot be combined with purely residential, commercial, or even other mixed-use properties. Also, the new guidance continues to withhold triple-net leases from the safe harbor.
Another favorable change in the safe harbor makes the contemporaneous record-keeping requirements less stringent.
As with other “safe harbor” rulings, taxpayers can only be helped by the guidance. If a real estate enterprise does not meet the requirements, it can still qualify for the 20% deduction provided its owners can convince the IRS that it does indeed meet the definition of a “trade or business” under the tax law.