On January 18, the IRS published Final §199A regulations, new Proposed §199A regulations, Notice 2019-7 (rental real estate trade or business safe harbor) and Rev. Proc. 2019-11 (methods for calculating W-2 wages).
The guidance is positive in a number of areas, many of which were raised in ICSC’s October comment letter. Regrettably, it falls short in other areas, particularly by failing to clarify the treatment of triple-net-leased property.
Key highlights of the new guidance are below.
1031 Like-Kind Exchange Treatment
The final regulations do not reduce the unadjusted basis of property obtained in a like-kind exchange (LKEs). This reverses the position taken in the proposed regs which would have reduced the maximum amount of the deduction.
Mutual Funds that own REITs
New proposed regulations provide Registered Investment Companies (RICs), such as mutual funds, may pass the deduction for REIT dividends on to their shareholders.
W-2 wages
W-2 wages are not reduced by elective deferrals (such as retirement plan deferrals). New Rev. Proc. 2019-11 provides three alternative methods for computing W-2 wages, including a simplified method. Guaranteed payments do not count as W-2 wages
New rental real estate safe harbor
New Notice 2019-7 provides a safe harbor for real estate rentals – other than triple-net leases – involving over 250 annual rental service hours. This may be of limited benefit to the industry, however, due to the strict compliance requirements and the relatively high activity threshold.
Taxpayer must maintain separate books and records for each rental business and contemporaneous hours logs including (i) hours of all services performed; (ii) description of all services performed; (iii) dates on which such services were performed; and (iv) who performed the services. Rental services may be performed by owners or by employees, agents, and/or independent contractors of the owners.
Qualifying rental service hours 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.
Definition of a “Trade or Business” and impact to Triple Net Leased Property
The pass-through deduction applies to the qualified income of a “trade or business.” The definition of a “trade or business” was not defined in the tax reform law. Despite efforts by ICSC and the real estate industry to apply a broad definition, the final regulations settled on a narrower standard under section 162 of the tax code. As a result, each triple-net-leases must be considered on their individual facts or circumstance.
The guidance notes relevant factors might include, but are not limited to:
- The type of rented property (commercial real property versus residential property),
- The number of properties rented,
- The owner’s or the owner’s agent’s day-to-day involvement,
- The types and significance of any ancillary services provided under the lease; and
- The terms of the lease (for example, short-term versus long-term lease).
Aggregation rules
The final regulations largely adopt the aggregation framework as the proposed regulations, although expanded to allow aggregation at the partnership level. Aggregation requires a 50% or greater related ownership and requires 2 out of 3 of the following elements:
(A) The trades or businesses provide products, property, or services that are the same or customarily offered together,
(B) The trades or businesses share facilities or share significant centralized business elements, such as personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources, or
(C)The trades or businesses are operated in coordination with, or reliance upon, one or more of the businesses in the aggregated.
The net result of retaining the 50% common ownership requirement and the strict three-prong test is that aggregation will be off limited benefit to the real estate industry, where there are typically different capital partners.
The final regulations helpfully added "property" to the first prong to more clearly allow application to real estate. However, the final regs provide two examples that commercial and residential real estate are different enough that they do not satisfy the first prong. This means that a mixed-use real estate development with office and residential will either need to argue it is a single trade or business or meets the other two requirements.
Phillips Hinch
Vice President, Tax Policy