Shortly after Section 199A was added to the Code at the end of 2017, and again after the IRS proposed regulations under the newly-enacted provision last summer, many clients called us with the following question: “Will my rental real estate activities qualify for the 199A deduction?”

In most cases, we were able to answer confidently that the client’s activities would be treated as a qualified trade or business, and that the deduction would be available, though it could be limited by the so-called “W-2 Wages and Unadjusted Basis” limitations.

In a few others, we were able to reply just as certainly that the activities did not rise to the level of a trade or business and, so, would not qualify for the deduction.

In some cases, however, we had to delve more deeply into the client’s particular facts and circumstances before we could reach any conclusion – often with the proviso that the IRS may disagree with our assessment of the situation.

“Trade or Business”

Like many other areas of the tax law, Section 199A requires a taxpayer to make a threshold determination of whether its activities rise to the level of constituting a trade or business.[i]

In general, courts have held that in order for a taxpayer’s activity to rise to the level of constituting a trade or business, the taxpayer must satisfy two requirements: (1) regular and continuous conduct of the activity, which depends on the extent of the taxpayer’s activities;[ii] and (2) a primary purpose to earn a profit, which depends on the taxpayer’s state of mind and their having a good faith intention to make a profit from the activity.[iii]

Whether a taxpayer’s activities meet these factors depends on the facts and circumstances of each case.

In most situations, neither the taxpayer nor the IRS should find it difficult to evaluate the trade or business status of the taxpayer’s activities – the level and quality of the activity will be such that its status will be obvious.

Unfortunately, there remain a number of cases in which the various “triers of fact” – first, the taxpayer, then the IRS, and finally the courts – will have to consider to the taxpayer’s unique “facts and circumstances” in determining whether the taxpayer’s activities rise to the level of a trade or business.

Because it is fact-intensive, while also being subjective, this analytical process can be costly and time-consuming.

It can also generate seemingly inconsistent conclusions by the ultimate trier of fact, a concern that has been borne out historically in the evaluation of smaller rental real estate operations.

Section 199A

One needs to keep the forgoing in mind in order to understand the tentative reaction to the enactment of Section 199A by the owners of many smaller rental real estate operations.

Section 199A provides a deduction to a non-corporate taxpayer[iv] of up to 20 percent of the taxpayer’s qualified business income from each of the taxpayer’s “qualified trades or businesses,” including those operated through a partnership, S corporation, or sole proprietorship, effective for taxable years beginning after December 31, 2017.[v]

Although the passage of Section 199A was greeted enthusiastically by most in the business community, some business owners withheld their endorsement of the provision pending the issuance of guidance as to meaning of certain key terms in the statute.

The rental real estate sector, in particular, hoped that the term “qualified trade or business” would be defined so as to provide its members with some certainty as to the application of the Section 199A deduction to their activities.

However, the statute defined a “qualified trade or business” as any trade or business other than a specified service trade or business or a trade or business of performing services as an employee.

Moreover, the legislative history failed to provide a definition of trade or business for purposes of section 199A.

Proposed Regulations

When the IRS proposed regulations in August of 2018, it stated that Section 162(a)[vi] of the Code provides the most appropriate “definition” of a trade or business for purposes of Section 199A.[vii]

The IRS explained that its decision was based on the fact that the definition of trade or business for purposes of Section 162 is derived from a large body of existing case law and administrative guidance interpreting the meaning of “trade or business” in the context of a broad range of industries.

For this reason, the IRS concluded that the definition of a trade or business under Section 162 provides for administrable rules that are appropriate for the purpose of Section 199A, and which taxpayers have experience applying.

That being said, the proposed regulations extended the definition of trade or business for purposes of Section 199A beyond Section 162 in one circumstance.

Solely for purposes of Section 199A, the IRS proposed that the rental of real property to a related trade or business would be treated as a trade or business if the rental and the other trade or business were commonly controlled. In supporting this extension, the IRS explained that it is not uncommon, for legal or other non-tax reasons, for taxpayers to segregate a rental property from an operating business. According to the IRS, this rule would allow taxpayers to effectively aggregate their trades or business with the associated rental property.[viii]

Notwithstanding the foregoing, the IRS received comments from advisers and industry groups that the status of a rental real estate enterprise as a trade or business within the meaning of Section 199A remained a subject of uncertainty for many taxpayers.

Final Regulations[ix]

The final regulations retained the proposed regulation’s definition of trade or business; specifically, for purposes of Section 199A and the regulations thereunder, a “trade or business” continues to be defined as a trade or business under Section 162 of the Code.[x]

The IRS acknowledged comments suggesting guidance in the form of a regulatory definition, a bright-line test, or a factor-based test.[xi] The IRS rejected these, however, pointing out that whether an activity rises to the level of a Section 162 trade or business is inherently a factual question, and the factual setting of various trades or businesses varies so widely, that a single rule or list of factors would be difficult to provide in a manageable manner, and would be difficult for taxpayers to apply.[xii]

However, the IRS also recognized the difficulties that a taxpayer may have in determining whether their rental real estate activity is sufficiently regular, continuous, and considerable for the activity to constitute a Section 162 trade or business.

Proposed Safe Harbor

To help mitigate the resulting uncertainty, the IRS recently proposed – concurrently with the release of the final Section 199A regulations – the issuance of a new revenue procedure that would provide for a “safe harbor” under which a taxpayer’s “rental real estate enterprise”[xiii] will be treated as a trade or business for purposes of Section 199A.[xiv]

To qualify for treatment as a trade or business under this safe harbor, a rental real estate enterprise must satisfy the requirements of the proposed revenue procedure. If the safe harbor requirements are met, the real estate enterprise will be treated as a trade or business for purposes of applying Section 199A and its regulations.

Significantly, an S corporation or a partnership[xv] (pass-through entities; “PTE”) that is owned, directly or indirectly, by at least one individual, estate, or trust may also use this safe harbor in order to determine whether a rental real estate enterprise conducted by the PTE is a trade or business within the meaning of Section 199A.[xvi]

Rental Real Estate Enterprise

For purposes of the safe harbor, a “rental real estate enterprise” is defined as an interest in real property held for the production of rents; it may consist of an interest in one or in multiple properties.

The individual or PTE relying on the proposed revenue procedure must hold the interest directly or through an entity that is disregarded as an entity separate from its owner for tax purposes.[xvii]

A taxpayer may treat each property held for the production of rents as a separate enterprise; alternatively, a taxpayer may treat all “similar” properties held for the production of rents as a single enterprise.[xviii] The treatment of a taxpayer’s rental properties as a single enterprise or as separate enterprises may not be varied from year-to-year unless there has been a “significant”[xix] change in facts and circumstances.

Commercial and residential real estate may not be part of the same rental enterprise; in other words, a taxpayer with an interest in a commercial rental property, who also owns an interest in a residential rental, will be treated as having two rental real estate enterprises for purposes of applying the revenue procedure.

Rental as Section 199A Trade or Business

A rental real estate enterprise will be treated as a trade or business for a taxable year (solely for purposes of Section 199A) if the following requirements are satisfied during the taxable year with respect to the rental real estate enterprise:

(A) Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise, as well as a separate bank account for each enterprise;[xx]

(B) For taxable years beginning:

(i) prior to January 1, 2023, 250 or more hours of “rental services”[xxi] are performed per year with respect to the rental enterprise;

(ii) after December 31, 2022, in any three of the five consecutive taxable years that end with the taxable year (or in each year for an enterprise held for less than five years), 250 or more hours of rental services are performed per year with respect to the rental real estate enterprise; and

(C) The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, regarding the following:

(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.

Such records are, of course, to be made available for inspection at the request of the IRS.[xxii]

Rental Services

The rental services to be performed with respect to a rental real estate enterprise for purposes of satisfying the safe harbor include the following:

(i) advertising to rent or lease the real estate;

(ii) negotiating and executing leases;

(iii) verifying information contained in prospective tenant applications;

(iv) collection of rent and payment of expenses;

(v) daily operation, maintenance, and repair of the property;

(vi) management of the real estate;

(vii) provision of services to tenants;[xxiii]

(viii) purchase of materials; and

(ix) supervision of employees and independent contractors.[xxiv]

Rental services may be performed by the individual owners (in the case of direct ownership of the real property) or by the PTE that owns the property, or by the employees, agents, and/or independent contractors of the owners.

It is important to note that hours spent by an owner or any other person with respect to the owner’s capacity as an investor are not considered to be hours of service with respect to the enterprise. Thus, the proposed revenue procedure provides that the term “rental services” does not include the following:

(i) financial or investment management activities, such as arranging financing;

(ii) procuring property;

(iii) studying and reviewing financial statements or reports on operations;

(iv) planning, managing, or constructing long-term capital improvements; or

(v) traveling to and from the real estate.[xxv]

Real estate used by the taxpayer (including by an owner of a PTE relying on this safe harbor) as a residence for any part of the year[xxvi] is not eligible for the safe harbor.

Real estate rented under a triple net lease is also not eligible for the safe harbor – it more closely resembles an investment than a trade or business. For purposes of this rule, a “triple net lease” includes a lease agreement that requires the tenant to pay taxes, fees, and insurance, and to be responsible for maintenance activities for a property in addition to rent and utilities. This also includes a lease agreement that requires the tenant 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.

Procedural Requirements, Reliance

A taxpayer or PTE must include a statement attached to the return on which it claims the Section 199A deduction or passes through Section 199A information that the requirements in the revenue procedure have been satisfied. The statement must be signed by the taxpayer, or an authorized representative of an eligible taxpayer or PTE, which states:

Under penalties of perjury, I (we) declare that I (we) have examined the statement, and, to the best of my (our) knowledge and belief, the statement contains all the relevant facts relating to the revenue procedure, and such facts are true, correct, and complete.

The individual or individuals who execute the statement must have personal knowledge of the facts and circumstances related to the statement.

If an enterprise fails to satisfy these requirements, the rental real estate enterprise may still be treated as a trade or business for purposes of Section 199A if the enterprise otherwise meets the general definition of trade or business.[xxvii]

The proposed revenue procedure is proposed to apply generally to taxpayers with taxable years beginning after December 31, 2017; i.e., the effective date for Section 199A.

In addition, until such time that the proposed revenue procedure is published in final form, taxpayers may use the safe harbor described in the proposed revenue procedure for purposes of determining when a rental real estate enterprise may be treated as a trade or business solely for purposes of Section 199A.

What’s Next?

All in all, the final regulations and the proposed safe harbor should provide some welcomed relief and “certainty” for those individual taxpayers and PTEs that own smaller rental real estate operations;[xxviii] and they came just in time – barely – for the preparation of these taxpayers’ 2018 tax returns.

But the proof is in the pudding – or something like that – and the actual impact of the proposed safe harbor will have to await the collection and analysis of the relevant data, including the reactions of taxpayers and their advisers.

As in the case of many other taxpayer-friendly regulations or procedures,[xxix] the benefit afforded requires that the taxpayer be diligent in maintaining contemporaneous, detailed records for each rental real estate enterprise. This may be a challenge for many a would-be qualified trade or business.

Whether to treat “similar” rental properties as a single enterprise may also present some difficulties for taxpayers, at least until they figure out what it means for one property to be similar to another. Based upon the term’s placement in the proposed revenue procedure, it may be that all residential properties are similar to one another, just as all commercial properties are similar to one another. In that case, a taxpayer may be able to treat all of its residential rentals, for example, as a single enterprise, which may allow it to satisfy the “250 or more hours of rental service” requirements of the safe harbor.

Just as challenging may be a taxpayer’s distinguishing between business-related services and investment-related services.[xxx]

Regardless of how the proposed safe harbor is ultimately implemented and administered, the fact remains that the IRS has clearly considered and responded to the requests of the rental real estate industry.

The questions remain, however: Will Section 199A survive through its scheduled expiration date in 2025; and, if so, will it become a “permanent” part of the Code? Or is all this fuss just a way to drive folks like me crazy?


For example, expenses are deductible if they are incurred “in carrying on any trade or business.” IRC Sec.162.

[ii] Which may distinguish a trade or business from an “investment.”

[iii] As opposed to a “hobby.”

[iv] Individuals; also trusts and estates.

[v] Tax Cuts and Jobs Act, PL 115-97, Sec. 11011. The deduction disappears for taxable years beginning after December 31, 2025.

[vi] In general, Section 162 of the Code provides that the ordinary and necessary expenditures directly connected with or pertaining to a taxpayer’s “trade or business” are deductible in determining the taxpayer’s taxable income.


[viii] The final regulations clarify the rule by limiting its application to situations in which the related party tenant is an individual or an PTE (not a C corporation).


[x] Other than the trade or business of performing services as an employee.

[xi] It also considered and rejected suggestions that it define trade or business by reference to Section 469 of the Code, explaining that the definition of trade or business for Section 469 purposes is significantly broader than the definition for purposes of Section 162 as it is intended to capture a “larger universe” of activities, including passive activities. According to the IRS, Section 469 was enacted to limit the deduction of certain passive losses and therefore, serves a very different purpose than the allowance of a deduction under section 199A. Further, Section 199A does not require that a taxpayer materially participate in a trade or business in order to qualify for the Section 199A deduction.

The IRS also declined to adopt a suggestion that all rental real estate activity be deemed to be a trade or business for purposes of Section 199A.

[xii] In determining whether a rental real estate activity is a section 162 trade or business, relevant factors might include, but are not limited to (i) the type of rented property (commercial real property versus residential property), (ii) the number of properties rented, (iii) the owner’s or the owner’s agents day-to-day involvement, (iv) the types and significance of any ancillary services provided under the lease, and (v) the terms of the lease (for example, a net lease versus a traditional lease and a short-term lease versus a long-term lease).

[xiii] Yes, another defined term.

[xiv] Notice 2019-07.

[xv] Other than a publicly traded partnership.

[xvi] You may recall that it is up to the PTE (not its owners) to determine whether it is engaged in a qualified trade or business.

[xvii] Reg. Sec. 301.7701-3; for example, a single-member LLC; so, two tiers of entities at most (one of which must be disregarded) – an S corp. that owns an interest in a 2-person partnership that owns rental real estate would not qualify.

[xviii] There is no in-between, where some similar properties are treated as one enterprise while others as separate enterprises.

[xix] As of yet undefined.

[xx] Query how this may affect a taxpayer’s decision to treat all “similar” properties held for the production of rents as a single enterprise?

[xxi] You guessed it. C’mon, it’s tax – we love defined terms within defined terms. They put Russian nesting dolls to shame.

[xxii] The contemporaneous records requirement will not apply to taxable years beginning prior to January 1, 2019.

[xxiii] Although not spelled out in the proposed revenue procedure, presumably this includes some of the following: providing and paying for gas, water, electricity, sewage, and insurance for the property; paying the taxes assessed thereon; providing insect control, janitorial service, trash collection, ground maintenance, and heating, air conditioning and plumbing maintenance.

[xxiv] This does not purport to be an all-inclusive list.

[xxv] The number of times I have seen taxpayers count such travel time in trying to establish their material participation for purposes of the passive activity rules!

[xxvi] Under section 280A of the Code. In general, a taxpayer uses a property during the taxable year as a residence if he uses such property for personal purposes for a number of days which exceeds the greater of: 14 days, or 10 percent of the number of days during such year for which such property is rented at a fair rental.

[xxvii] Under Section 162, which may be small comfort – after all, that’s why the safe harbor was proposed.

[xxviii] Not that everything was rosy. Example 1 of proposed §1.199A-1(d)(4) described a taxpayer who owns several parcels of land that the taxpayer manages and leases to airports for parking lots. The IRS shared that some taxpayers questioned whether the use of the lease of unimproved land in the example was intended to imply that the lease of unimproved land is a trade or business for purposes of section 199A. The IRS explained that the example was intended to provide a simple illustration of how the 199A calculation would work; it was not intended to imply that the lease of the land is, or is not, a trade or business for purposes of section 199A beyond the assumption in the example. In order to avoid any confusion, the final regulations removed the references to land in the example.

[xxix] For example, the material participation regulations under Reg. Sec. 1.469-5T.

[xxx] For example, attending a hearing of a local zoning board.

Why Real Property?

It is not unusual for the owners of a closely held business to also own a number of real properties. For example, they may own real property that:

  • headquarters the business;
  • serves as a warehouse for the business;
  • serves as parking for a fleet of vehicles used by the business;
  • they want to keep out of the hands of a competitor;
  • is located in proximity to the business and could be used for future growth;
  • is located in a different geographic region into which the business plans to expands; or
  • serves as a solid investment for excess cash that was generated through the business.

In most cases, the business will occupy the entire property. If the owners have been well-advised, the property is housed in an LLC (not a corporation) of which they (not the business) are the members, while a different entity holds the business and uses the property pursuant to an arm’s-length lease.

Rental Real Estate = Passive Activity?

In many cases, however, the business is not the sole tenant; in some cases, the business does not use the property at all. In those situations, the owners must be alert to the application of the passive loss rules, and the consequences thereof, as illustrated by a recent decision.

Taxpayer ran an architectural business. During Tax Year, he spent 109 hours providing architectural services to Bank and about 540 hours providing similar services to Construction Co.

During Tax Year, Taxpayer owned and managed two residential rental properties: a single building containing four separate apartments, plus a single-family home. He made weekly trips to the properties to ensure that trash bins were set out for collection, cleaned if necessary, and returned to their storage locations. He also performed minor repairs at the properties, coordinated more substantial repairs with a handyman, communicated with the tenants and collected and deposited rent, maintained insurance policies, purchased materials for the properties as needed, paid bills, and kept books and records of his expenses for tax accounting purposes.

Two of the four tenants moved out during Tax Year. As a result, Taxpayer spent additional time coordinating with them as they vacated the apartments, performed extra repair and maintenance work to ready the apartments for new tenants, placed advertisements listing the apartments for rent, and worked with new tenants as they signed leases and moved into the apartments.

Taxpayer was late paying property taxes and insurance premiums on both rental properties during Tax Year. Consequently, he was obliged to spend time negotiating a property tax installment payment plan, and had to work with his mortgage lender to eliminate redundant insurance coverage on the properties.

Tax Return and IRS’s Determination

Taxpayer timely filed IRS Form 1040, U.S. Individual Income Tax Return, for Tax Year. He reported gross receipts from his architectural business as a sole proprietor – on Schedule C, Profit or Loss from Business – offset by various expenses.

He also attached Schedule E, Supplemental Income and Loss, to his tax return, reporting gross rental income from the two properties, offset by expenses that resulted in a net loss from the rental activity, which Taxpayer reported in computing his taxable income.

The IRS determined that Taxpayer’s rental loss deduction was disallowed under the passive activity loss rules,[1] and assessed a deficiency in Taxpayer’s Federal income tax for Tax Year.

Taxpayer petitioned the Tax Court. The sole issue for decision was whether the loss that Taxpayer reported on Schedule E should be disallowed under the passive activity loss limitations.

Court’s Opinion

The Court began by stating that, as a general rule, the IRS’s determination of a taxpayer’s liability in a notice of deficiency is presumed correct, and the taxpayer bears the burden of proving that the determination is incorrect.

Deductions, the Court continued, are a matter of legislative grace, and the taxpayer generally bears the burden of proving entitlement to any deduction claimed. Specifically, a taxpayer must substantiate any deductions claimed by keeping and producing adequate records that enable the IRS to determine the taxpayer’s correct tax liability.

The Court noted that Taxpayer produced an activity log listing the personal services that he performed in managing the rental properties during Tax Year and the time that he spent providing those services. The activity log indicated that he devoted 765 and 372 hours to the management of the two properties, respectively.

Taxpayer also produced records of his email exchanges with his tenants and mortgage brokers (related to his attempts at refinancing the mortgages on the properties), and numerous receipts from home improvement stores and other vendors related to the management of, and repairs undertaken at, the rental properties.

Passive Activity

In determining their taxable income, taxpayers are allowed deductions for certain business and investment expenses. However, the Code generally disallows any deduction for so-called “passive activity” losses.

A passive activity loss is defined as the excess of the aggregate losses from all passive activities for a taxable year over the aggregate income from all passive activities for that year.

A passive activity is any activity that involves the conduct of a trade or business, or an investment activity the expenses of which are deductible as incurred for the production of income, in which the taxpayer does not materially participate.

A passive activity loss may not be used to offset non-passive income (in Taxpayer’s case, the income from his architectural business).

Rental Activities

A rental activity generally is treated as a per se passive activity regardless of whether the taxpayer materially participates. The term “rental activity” generally is defined as any activity where payments are principally for the use of tangible property.

The Code provides special rules for taxpayers engaging in real property businesses. Under these rules, the rental activities of a qualifying taxpayer in a real property trade or business – i.e., a “real estate professional” – are not per se passive activities and, if the taxpayer materially participates in the rental real estate activities, these activities are treated as non-passive activities.

A taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a regular, continuous, and substantial basis.[2]

A taxpayer qualifies as a real estate professional during a taxable year if:

  • more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates; and
  • the taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.[3]

“Personal services” means any work performed by an individual in connection with a trade or business.

In accordance with the flush language of the Code, Taxpayer elected to treat all of his interests in rental real estate as one activity for purposes of the special rule applicable to real estate professionals.


The extent of a taxpayer’s participation in an activity, including evidence of the number of hours that they participate in a real property trade or business, may be established by any reasonable means.

Contemporaneous daily time reports, logs, or similar documents are generally not required – though they should certainly recommended – if the extent of such participation may be established by other reasonable means. Reasonable means may include, but are not limited to, the identification of the services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.

The Court pointed out that a post-event “ballpark guesstimate” will not suffice to establish the extent of one’s participation.

Although Taxpayer worked about 650 hours providing personal services as an architect during Tax Year, the record, including his activity log and other records, showed that he also spent more than 750 hours providing personal services in connection with the management of the rental properties. Taxpayer also offered credible testimony describing the time and effort that he devoted to both activities during the year. His testimony was largely corroborated with objective evidence, including a rental activity log, receipts for various rental-related expenditures, emails, and other business records.[4]

Considering all the facts and circumstances, the Court found that Taxpayer qualified as a real estate professional during Tax Year, and that his rental real estate activities were regular, continuous, and substantial within the meaning of the passive loss rules.

Thus, the Court concluded, the loss deduction claimed by Taxpayer was not disallowed as a passive loss, and could be applied against Taxpayer’s business income.

Forewarned . . . Means No Surprises

I don’t care for surprises, nor do most business owners, at least insofar as their taxes are concerned.

In order to avoid such surprises, those business owners who also own rental real property that is not related to the owner’s primary business,[5] must be familiar with the limitations imposed by the passive loss rules, and they must be prepared to maintain records of their rental-related activities on a contemporaneous basis.

Although this level of diligence may seem like a chore to the owner, it could provide a commensurate level of certainty as to the tax treatment of the activity and of any losses generated by the activity, not to mention a reduction in the professional fees to be incurred in defending the taxpayer’s return on audit.

[1] The IRS acknowledged in the notice of deficiency that Taxpayer was entitled to deduct $25,000 of the loss in accordance with the exception prescribed in IRC Sec. 469(i). Under this rule, a taxpayer who “actively” participates in rental real estate activities may deduct up to $25,000 per year for related passive activity losses.

[2] IRS Regulations identify various tests to determine whether a taxpayer satisfies the “material participation” requirement.

[3] The term “real property trade or business” means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.  Taxpayer did not contend that his work as an architect constituted a real property trade or business.

[4] The Court observed that Taxpayer may have exaggerated the number of hours recorded in his rental real estate activity log; for example, the Court disregarded the hours that Taxpayer listed for vehicle maintenance. Nevertheless, the record as a whole showed that Taxpayer spent at least 750 hours managing the rental properties in Tax Year.

[5] In some cases, it may be possible for the business owner to “group” his primary business activity with his related rental activities, provided the two activities constitute an “appropriate economic unit” (for example, because of interdependencies between them), and the rental activity is “insubstantial” in relation to the business activity, or each owner of the business has the same proportionate interest in the rental activity. In this way, the rental activity may avoid being characterized as passive.