The way in which the Section 199A tax deduction applies to rental property can be confusing. Find full details about this complex IRS tax issue below.

Regrettably, the most misunderstood issue for preparing taxes could be the most significant - the issue of when a rental activity is a trade or business qualified for the Sec 199A deduction. The final regulation (§1.199A-1(b)(14)) defines a trade or business as being the same as trade or business under Code Sec. 162.  Whether a taxpayer is engaged in a trade or business under section 162 requires an examination of all the facts and circumstances. (Higgins v. Commissioner, 312 U.S. 212 (1941))

The courts have laid out two conditions necessary for an activity to be a trade or business. The first requires the taxpayer to carry on the activity with the intent of making a profit. (See Ferrell v. Commissioner, 90 T.C. 1154 (1988) and Dreicer v. Commissioner, 78 T.C. 642, 645 (1982), aff'd without opinion 702 F.2d 1205 (D.C. Cir. 1983)) The second requires the scope and level of taxpayer activity to be considerable, regular, and continuous. (See Groetzinger v. Commissioner (U.S. Supreme Court) 480 U.S. 23, at 32, 35 (1987)).

Appying these two conditions to Rental Real Estate - The Treasury/IRS regulation writers received a number of requests for “bright line rules” to help taxpayers and tax preparers determine whether a rental real estate activity is a trade or business. In response Treasury/IRS issued Notice 2019-07, followed by Rev Proc 2019-38, creating a safe harbor to address this issue.

To quote a close friend of mine, “dealing with rentals and Sec 199A for 2018 is like sitting in the front seat between Bonnie and Clyde.” Making the ultimate decision that a rental activity is a trade or business solely on the basis of the Notice 2019-07 and RP 2019-38 safe harbor can lead to big problems. The 199A deduction takes into account both positive (net profit) and negative (net loss) qualified business income (QBI) and negative QBI reduces the positive QBI from other activities, and in doing so, reduces the 199A deduction. Thus, if a loss activity qualifies under Sec. 162 and it is not treated as a trade or business because it did not meet the 250-hour safe harbor, that does not preclude the IRS from determining it is a trade or business based upon Sec 162. The best way to look at the safe harbor is the IRS will not challenge your position that the rental IS a trade or business, BUT it is not a safe harbor that a rental is NOT a trade or business.

On January 18, 2019, the IRS issued Notice 2019-07 which provided the language of a proposed revenue procedure – ultimately Rev Proc 2019-38 – for “safe harbor” conditions under which a rental real estate activity will be treated as a trade or business for purposes of the 199A deduction.

It’s important to note that there are three “safe harbor” conditions that if met for a rental real estate enterprise (enterprise is a tax term introduced by the IRS in Notice 2019-07), the rental real estate enterprise (RREE) will be deemed to be a trade or business and eligible for the section 199A 20% deduction. For purposes of this safe harbor, a rental real estate enterprise is defined as an interest in real property held for the production of rents and may consist of an interest in multiple properties.

All the following requirements must be satisfied for the safe harbor:

a. A real estate enterprise can consist of a single or multiple real estate rentals.

b. Commercial and residential rentals cannot be combined in the same real estate enterprise.

2. For RREEs in existence less than 4 years, at least 250 hours of rental services must be performed for the year in question with reference to each RREE. For RREEs that have been in existence for at least 4 years, in any 3 of the 5 consecutive taxable years that end with the taxable year, the 250-hour requirement must be met.

3. The taxpayer must maintain contemporaneous records, including time reports, logs, or similar documents, to document the following:

a. hours of all services performed.

b. description of all services performed.

c. dates on which such services were performed; and

d. who performed the services.

Rental services that may be counted toward the 250-hour requirement include: (i) advertising to rent or lease the real estate; (ii) negotiating and executing leases; (iii) verifying information contained in tenant applications; (iv) collecting rent; (v) daily operation, maintenance, and repair of the property; (vi) management of the real estate; (vii) purchase of materials for operation such as repairs; and (viii) supervision of employees and independent contractors.

However, rental services do NOT include 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.

Rental services counted toward the 250-hour requirement may be performed by owners or employees, agents, and/or independent contractors working for the owners.

Notice 2019-07 and Rev Proc 2019-38 specify that real estate rented or leased under a triple net lease agreement is not eligible for this safe harbor. 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 maintenance activities for a property in addition to rent and utilities. Also, ineligible for the safe harbor is a property leased under an 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.

Real estate used as a residence by the taxpayer for any portion of the taxable year is not eligible for the safe harbor rules (see converted homes below).

Real estate used by the taxpayer (including an owner or beneficiary of a relevant passthrough entity relying on this safe harbor) as a residence for any part of the year under section 280A is not eligible for this safe harbor.

(1) A description (including the address and rental category*) of all rental real estate properties that are included in each rental real estate enterprise.

(2) A description (including the address and rental category*) of rental real estate properties acquired and disposed of during the taxable year; and

(3) A representation that the requirements of Rev Proc 2019-38 have been satisfied.

*Residential or commercial

If an individual with more than one rental REE is relying on the safe harbor, a single statement may be submitted but the statement must list the required information separately for each rental REE.

The revenue procedure states that taxpayers may not vary this treatment (i.e., treating each rental as a separate enterprise or grouping rentals as an enterprise) from year-to-year.

The 199A deduction is 20% of a taxpayer’s qualified business income from all of the taxpayer’s trades or businesses subject to certain limitations. Many rentals do not show a profit and a rental that is treated as a trade of business that shows a deductible loss for the year will reduce the qualified business income of other trades or businesses of an individual, and as a result, reduces the 199A deduction of that individual.

This raises a serious due diligence question for tax preparers. Suppose a client does meet the safe harbor rules or qualifies as a trade or business under IRC Sec 162 and ends up with a deductible rental loss. Can this loss be omitted from the QBI calculation? The answer is obvious: if it meets the definition of a trade or business, of course it must be included in the computation of the Sec 199A deduction. To make matters more complicated, just because a rental does not meet the safe harbor rules does not mean it is not a trade or business under IRC Sec 162. The safe harbor criteria only means the IRS won’t challenge the presumption that it is trade or business, nothing more.

CAUTION - Interest paid as part of a trade or business rental real estate activity is subject to the section 163(j) limitation on business interest UNLESS the rental real estate activity elects under Sec 163(j)(7)(B) to be an “electing real property trade or business”. The effect of this election is that the rental activity, though a trade or business, is not subject to the Sec 163(j) limitation.  It's important to note, however, that there is a small business gross revenue exception from the Sec 163(j) limitation for any Sec 162 trade or business, whether it is a rental activity, where in the 3 prior years the gross annual revenues are less than $31 million for 2025. Given the high dollar amount before the Sec 163(j) interest limitation applies, most rentals will not be subject to the limitation and there won’t be a need to make the Sec 163(j)(7)(B) election.    

The final regulation (§1.199A-1(b)(14)) defines a trade or business as being the same as a trade or business under Code Sec 162. However, Code Sec 162 is based on a myriad of court cases and IRS rulings that require the tax preparer to make a subjective determination which can be challenged by the Service. The catch-22 here is that IRS can determine a rental is a trade or business under Sec 162 even if it did not meet the safe harbor of Notice 2019-07. (You’ll notice in the court cases we’ve cited that the IRS will sometimes argue that a rental is a trade or business, and in other cases will take the position that a rental is not a trade or business.) With regard to the Sec 199A deduction, a rental activity with a net profit benefits the taxpayer if it is a trade or business, but if the rental has a net loss, it is a disadvantage since a net loss will offset any net profit from other business activities. You can’t arbitrarily make those decisions to help a client; the decisions have to be based on facts and circumstances.    

We see two problems facing tax practitioners: