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Subject: Alan Gassman, John Beck & Brandon Ketron - One Particular Harbor, New Regulatory Guidance on If and When a Rental Real Estate Activity Can Qualify for the 20% Section 199A Deduction

“The time is now to reach out to clients who have rental properties, convert triple net leases to be able to qualify under the statute, and make sure that clients, or their employees and agents, are spending at least 250 hours a year doing the right things. While at it, we can explain what entities clients should have their real estate in, determine if they have sufficient unadjusted basis immediately after acquisition (UBIA) of their qualified properties, and talk to them about other planning opportunities.”

Alan Gassman, Brandon Ketron and John Beck provide members with commentary that focuses on if and when a rental real estate activity can qualify for the 20% section 199A deduction under the final regulations.

Alan Gassman, JD, LL.M. is the founding partner of the law firm of Gassman, Crotty & Denicolo, P.A. in Clearwater, Florida. Alan is a frequent contributor to LISI, and has authored several books and many articles on Estate and Estate Tax Planning, Trust Planning, Creditor Protection Planning, and associated topics. You can contact Alan at [email protected].

Brandon Ketron, CPA, JD, LL.M. is an associate at the law firm of Gassman, Crotty & Denicolo, P.A., in Clearwater, Florida and practices in the areas of Estate Planning, Tax, and Corporate and Business Law. Brandon is a frequent contributor to LISI and presents webinars on various topics for both clients and practitioners. Brandon attended Stetson University College of Law where he graduated cum laude, and received his LL.M. in Taxation from the University of Florida. He received his undergraduate degree at Roanoke College where he graduated cum laude with a degree in Business Administration and a concentration in both Accounting and Finance. Brandon is also a licensed CPA in the states of Florida and Virginia. His email address is [email protected].

John Beck, JD, LL.M. is an associate at the law firm of Gassman, Crotty & Denicolo, P.A., in Clearwater, Florida and practices in the areas of Estate Planning, Tax, and Corporate and Business Law. His email address is john@gassmanpacom.

Here is their commentary:

EXECUTIVE SUMMARY:

The lyrics to the song, ,1 by tell the story of a sailor who finds the ideal destination after many voyages. Real estate investors have been looking for a harbor since Section 199A was passed in December of 2017, particularly with respect to if and when leasing activities would be considered as an active trade or business under the statute.

The IRS and Treasury Department have now defined “one particular harbor” in a way that allows a great many landlords to moor their boats into and relax, knowing that they will receive the Section 199A deduction. It is hard to fathom that just four days ago there was so much less clarity than today for those who are able to have at least 250 hours a year spent on legitimate rental activities.

“The sea (and 199A) is in my veins”

I’ve had enough tax advisors’ refrains

And “I’m just glad I don’t [rent out] a trailer”2

FACTS:

The new tax law passed in December of 2017 includes a provision that allows a deduction of up to 20% for an individual, a trust, or an estate that has income, or receives income, through a partnership or S-corporation organization that is a “trade or business” as defined under certain parts of the Internal Revenue Code. Proposed regulations that were released over the summer gave little guidance on if and when a rental real estate arrangement would be considered as an “active trade or business” for purposes of qualifying for the deduction, and case law guidance in this area is not very thorough.

On Friday, the IRS released new proposed final regulations that clarify many aspects of Section 199A and also, a special notice (Notice 2019-7), which provides tentative guidance and a request for comments on the sole subject of if and when a rental activity will be considered as an active trade or business. It is generally understood in the tax law community that a proposal like this can be relied upon, and that the eventual final Notice will be at least as taxpayer-friendly, and possibly friendlier, than what this new proposed safe harbor provides.

It is important to keep in mind that real estate investors can still rely upon the case law, and there will be situations where the safe harbor will not apply in “shelter[ing] you from the wind.”3 While the case law gives the taxpayer a strong degree of certainty, please do not try to “do this at home” because you will not be “safe within.”4 We have made this post as easy to understand as possible, but unless you are a skilled tax lawyer, CPA, or tax advisor, there is a chance that you may find yourself capsized or run aground.

The first thing we see is that the Notice provides that real estate rented or leased under a triple net lease is not eligible under the safe harbor even though a taxpayer who has an active business of entering into and selling triple net leases may still qualify under the case law.

The Notice defines a triple net lease to include an agreement that requires the tenant to pay taxes, fees, and insurance, and to be responsible for maintenance in addition to rent and utilities, and includes` lease agreements that require the tenant to pay common area maintenance expenses, which are where a tenant pays for its allocable portion of the rented property’s taxes, fees, insurance, maintenance activities, which are normally paid by the landlord.

The definition seems to leave open the ability to avoid triple net lease status by having the tenant be responsible for some portion of the maintenance, taxes, fees, insurances, and other expenses that would normally be payable by a landlord, and many landlords will be well-advised to offer significant rent reductions to tenants who are willing to pay for some part of one or more items, so that the landlord can fit within the safe harbor to reduce the effective tax rate on taxable income from 37% to 29.6%, in addition to whatever may be saved in state income taxes and state sales taxes as a result of such adjustments.

In addition, the safe harbor cannot be used by taxpayers (including an owner or beneficiary of a relevant pass-through entity) who rent their personal residences out for any part of the year. The safe harbor coins a new phrase, which is the “Rental Real Estate Enterprise.” This phrase is defined as an ownership interest in real estate that is rented and may consist of one or more properties.

An individual relying upon the safe harbor, or a partnership or S- corporation entity that owns the applicable interest in the real estate, the income from which may qualify for the Section 199A deduction, must own the real estate directly or through another entity that is disregarded for income tax purposes, like a “single member LLC.” A tax lawyer or other advisor should be consulted if the individual or the entity taxed as an S- corporation or partnership does not directly own the applicable real estate to see if the disregarded entity rules will apply.

Each individual taxpayer, estate, or trust can elect to treat each separate property as a separate enterprise, or all similar properties as a single enterprise, for purposes of applying the safe harbor rules, except that commercial and residential real estate cannot be considered as part of the same enterprise for testing purposes, and, of course, triple net leased real estate and real estate used as a residence by the taxpayer cannot qualify for the safe harbor.

As to each separate enterprise, the following requirements must be satisfied during each year to allow the income from the enterprise to be eligible for the safe harbor:

1. Separate books and records are maintained to reflect the income and expenses for each enterprise. This may require taxpayers who keep separate records for each separate property to also keep aggregate records if the properties are going to be considered to be grouped as a single enterprise.

2. Contemporaneous records, including time reports, logs, or similar documents are kept regarding the hours of all services performed, the description of all services performed, and the dates upon which the services were performed, as well as who performed the services with respect to tax years beginning January 1, 2019. This requirement will not apply for 2018 tax returns for fiscal year taxpayers for years that end prior to December 31, 2019.

“I used to rule my world from a pay phone

Ships out on the sea

But now times are rough

And I got too much stuff (including paperwork)

Can’t explain the likes of me”5

3. For 2018 through 2022, 250 or more hours of rental services must be performed to qualify the property for the safe harbor. Rental services include time spent by owners, employees, agents, and independent contractors of the owners, which can include management and maintenance companies, who have personnel who keep and provide the above-mentioned contemporaneous records. Time spent by computers that have artificial intelligence capability will not apply here, so taxpayers may elect to use low cost offshore call rooms and similar workers to effectuate many tasks that may add up to meet the time requirement (250 hours divided by 52 weeks is 4.8 hours a week or approximately 21 hours each month). This may involve providing tenants with additional services that can be provided by inexpensive call center employees, such as scheduling periodic inspections, insect treatments, insurance renewals and the condition of building systems, and also monitoring and reporting on such reporting items, and engaging in satisfaction surveys and other conversations with tenants, which will be a boom for offshore servicing centers and tenants and landlords who can enjoy these services.

The term “rental services” does not include arranging for financing or investing, buying property, studying and reviewing financial statements or reports, planning, managing or constructing long-term capital improvements, or time spent traveling to and from real estate.

Aside from the above exclusions, rental services that are included within the 250 hours of time required are as follows:

a. Advertising to rent or lease the properties;

b. Negotiating and executing leases;

c. Verifying information contained in tenant applications;

d. Collecting rent;

e. Daily operation, maintenance, and repair;

f. Management of the real estate;

g. Purchase of materials; and

h. Supervision of employees and independent contractors.

Conclusion

“Where it all ends I can’t fathom my friends

If I knew I might toss out my anchor

So I cruise along always searchin’ for songs

Not a lawyer a thief or a banker”6

The time is now to reach out to clients who have rental properties, convert triple net leases to be able to qualify under the statute, and make sure that clients, or their employees and agents, are spending at least 250 hours a year doing the right things.

While at it, we can explain what entities clients should have their real estate in, determine if they have sufficient unadjusted basis immediately after acquisition (UBIA) of their qualified properties, and talk to them about other planning opportunities.

Unfortunately, this safe harbor will not allow taxpayers with small boats to navigate successfully unless they can justify how 250 hours a year were spent on their properties. We are sure that commentators will request that the IRS allow for fewer hours when there are only one or two properties involved.

The Notice is to apply for taxable years ending after December 31, 2017 and can be relied upon until the final Revenue Procedure is published.

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!

Alan Gassman Brandon Ketron John Beck

CITE AS:

LISI Income Tax Planning Newsletter #170 (January 21, 2019) at http://www.leimbergservices.com Copyright 2019 Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Permission.

CITATIONS:

1 Jimmy Buffett, One Particular Harbour, on One Particular Harbour (MCA

Records 1983).

2 Jimmy Buffet, Son of a Son of a Sailor, on Son of a Son of a Sailor (ABC Records 1978).

3 Buffet, supra note 1.

4 Id.

5 Id.

6 Buffett, supra note 2.