Can Wisconsin Landlords with Triple Net Lease Agreements Benefit from the Safe Harbor IRC 2019-7 Option and §199A Tax Deduction?
The Tax Cuts and Jobs Act (“the Act”), passed at the end of 2017, made changes to the tax rates of various businesses, including rental real estate enterprises (RREE).
As will be discussed below, the problem for any landlord and their RREE is determining if the business qualifies as a “trade or business” under the Act. This will likely be partly determined by the type of leasing agreement used for the property, either a Gross Lease or a Triple Net Lease.
Under the Act, l landlords who either (i) use the RREE as a residence for any part of the year or (ii) use a Triple Net Lease agreement are not considered a trade or business for purposes of §199A, and therefore do not qualify for the tax benefits associated with §199A.
However, a safe harbor was newly created in 2019 which might help some landlords qualify for the tax benefit.
Understanding the Act and a RREE
It’s important to understand the background of the relationship between the Act and a RREE. The Act created opportunities and tax benefits for both corporate businesses and non-corporate businesses.
Specifically, for non-corporate businesses, §199A of the Internal Revenue Code (IRC) was created to provide a tax benefit for pass-through entities, such as: partnerships; limited liability companies (LLCs); and entities that have elected to be taxed under Subchapter S of the IRC (S-corps).
Generally, §199A allows a taxpayer to deduct up to 20% of their Qualified Business Income (called “the QBI deduction”) generated from a “trade or business.” The determination of whether income stems from a trade or business is determined under Section 162 of the IRC and has the same general meaning as it does for other purposes of tax law.
The haste in which the Act was passed created problems with interpreting and understanding §199A. For example, what is qualified business income (QBI)? What does “trade or business” mean for this new §199A tax benefit? Further, the application of §199A has proven difficult to define and understand as it relates to RREE and rental real estate income.
The introduction of a safe harbor, IRS regulation 2019-7
In early 2019, in response to these problems and at the request of tax professionals, the IRS issued final regulation 2019-7. Under regulation 2019-7, the IRS established a safe harbor. Under the safe harbor, certain RREEs may be treated as a “trade or business” solely for the purposes of §199A, thus qualifying for the QBI tax deduction.
The requirements of the safe harbor are:
1. The landlord must maintain separate books and records for each RREE. Under the proposed revenue procedure, landlords are generally permitted to treat each rental property as either a separate enterprise or as part of a single enterprise. However, commercial and residential properties may not be part of the same enterprise. Therefore, there is no safe harbor for mixed-use buildings. It is not clear if each piece of a mixed-use property can be tested separately.
For example: Landlord owns 5 rental properties; three residential and two commercial. Landlord has the option to treat each of the residential properties as either a single enterprise or as three separate enterprises for purposes of the safe harbor. Additionally, Landlord has the option to treat the two commercial properties as either the same or separate enterprises. Once the landlord decides whether to treat the rental properties as a single (all together) or separate enterprise, the landlord must continue to treat the properties in the same manner going forward.
2. Generally, 250 or more hours of “rental services” must be performed by or for each RREE annually. The 250 hours of rental services can be performed by landlords, owners, employees, agents, or independent contractors.
Rental services include:
- Advertising for rent or lease
- Negotiating and executing leases
- Verifying tenant applications
- Collection of rent
- Daily operation, maintenance, and repair of property
- Management of the real estate
- Purchase of materials
- Supervision of employees and independent contractors.
Rental Services do NOT include:
- 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
- Time spent traveling to and from real estate
3. Landlords will have to implement time tracking systems beginning in 2019 to rely on the safe harbor, and keep contemporaneous records. The 250-hour test will be applied annually. The records must be made available for inspection at the request of the IRS.
Landlord will have to maintain logs and records to document:
- Hours of services
- Description of services
- Dates such services were performed
- Who performed the service
What if a landlord does not meet the requirements of the safe harbor?
If a landlord does not meet the requirements of the safe harbor under the “self-rental” exception, there may still be options. The self-rental exception allows a RREE to be considered a “trade or business” if the tenant is commonly owned and generates QBI.
Under the self-rental exception, the real property is treated as a “trade or business” if the RREE and the tenant's operating trade or business are commonly controlled (i.e. more than 50% common ownership). Therefore, where an operating company leases real property from a related holding company, the RREE is considered a per se trade or business, even if it involves a triple net lease.
If the taxpayer does not qualify for the “self-rental” exception, then the analysis becomes an IRC §162 facts and circumstances determination of the landlord’s RREE. The outcome is not guaranteed. Some of the relevant factors the IRS may take into account include:
- The type of rented property (commercial versus residential versus mixed used)
- The number of properties rented
- The owner’s or the owner agent’s day-to-day involvement
- The types and significance of any ancillary services provided under the lease
- The terms of the lease (for example, a net lease versus a traditional lease and a short-term lease versus a long-term lease
Options for landlords to maximize benefits under§199A, in summary
Landlords who currently use the property as a residence or utilize a Triple Net Lease agreement may not be able to take advantage of the significant potential tax savings available under §199A. However, with a shift in a landlord’s business model, they may be able to qualify their rental real estate enterprise as a “trade or business” by meeting the requirements of the safe harbor. This would require a more active role in the management of the RREE, but would afford the landlord the opportunity to maximize the benefits under §199A.
Landlords with these and other tax issues should contact their accountant and legal counsel to discuss their existing business model and whether changes need to be made.
For questions about Triple Net Leases agreements and other tax matters, contact the attorneys at Murphy Desmond S.C. in Madison, Janesville, Appleton, and Dodgeville, Wisconsin.
Published May 31, 2019