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A Look at the Rental Real Estate Enterprise Safe Harbor in Notice 2019-7

by
Philip Storrer
on
3/4/2019
A Look at the Rental Real Estate Enterprise Safe Harbor in Notice 2019-7

This article published with the permission of tax notes® and the author.

Philip P. Storrer, CPA is a professor emeritus at California State University, East Bay. In this article, Storrer explores whether Notice 2019-7 is the best response to the request for clearer rental real estate rules.

I have two questions: First, does Notice 2019-7 teach us to be careful what we ask for? Second, is the notice a hammer in search of a nail?

I. What Did the Tax Community Ask For?

The IRS and Treasury issued Notice 2019-7 (which contains a proposed revenue procedure) in response to clamor from the tax community, particularly the tax preparation industry, for "bright line rules on whether a rental real estate activity is a section 162 trade or business." A Treasury official recently observed that the rules come just in time for millions of small business owners to file 2018 returns. 1

According to the summary of comments and explanation of revisions portion of the preamble to the final regs (T.D. 9847) issued February 8, "a majority of the comments received on the meaning of a trade or business focus on the treatment of rental real estate activities." 2

One such commentator who has "many clients who have rentals" understandably requested this issue be addressed in the final regulations to provide "fairness and clarity." 3

Congress used the complex structure of section 199A, consisting of 4,169 words, with subordinate as well as superintending clauses manifested in complicating phrases, to deliver a 20 percent deduction for passthrough profits to the non-C-corporation business world. How would the drafters have handled a 20 percent flat tax? Cynicism has gripped me.

The safe harbor described in Notice 2019-7 is an admitted attempt to mitigate what Treasury and the IRS confessed to be uncertainty for some taxpayers regarding whether a rental real estate enterprise (RREE) is considered a trade or business for purposes of section 199A. Treasury logically chose section 162 as the statutory crucible, so reg. section 1.199A-1(b)(14) defines a trade or business as "a trade or business under section 162." The RREE, which appears for the first time in the notice and the final regulations, shows promise to develop into a useful concept.

Under Notice 2019-7, taxpayers must satisfy three conditions to qualify for the section 162 safe harbor. Of those three, the requirement that separate books and records be kept for each RREE should not be difficult. But the two other conditions form what appears to be one compound requirement, that contemporaneous records be maintained to establish that 250 or more hours per year of rental services were performed by or on behalf of the landlord. As Yankees baseball legend Yogi Berra observed, "It's déjà vu all over again." Has the tax community forgotten the problematic contemporaneous recordkeeping requirements of other infamous code sections, including listed property under section 280F or the 750-hour threshold under section 469(c)(7)(B)(ii) to qualify as a real estate professional? I remember delivering seminars on the 1984 Deficit Reduction Act, parent to the listed property rules, and telling tax preparers, with tongue deeply in my cheek, "Don't worry about the records for computers and cellphones. Tell your clients to use the same recordkeeping system they're now using for their automobiles." Laughter invariably filled the room.

A cursory review of over 100 cases in which the 750-hour threshold for real estate professionals was in question revealed that only about 15 taxpayers were able to produce records that satisfied the courts.4 In contrast to the Notice 2019-7 safe harbor condition, section 469(c)(7)(B)(ii) does not require "contemporaneous daily reports . . . if the taxpayer can establish participation by other reasonable means."5 The contemporaneous requirement in the safe harbor notice makes the recordkeeping requirement much more difficult to satisfy. What does contemporaneous mean for the purpose of the 250-hour requirement? Temporary regulations6 describing contemporaneous in other contexts (use of auto) define the term as "at or near the time of the expenditure."

A closed member-only tax forum7 undoubtedly captures what must be a broad consensus of tax preparer community: "It seems that it would be virtually impossible to meet the 250-hour service requirement (including owner and others working on behalf of the owner) with just a few single-family residences."

So while the harbor must certainly be safe, it will be, to many, virtually impossible to take advantage of. The mouth of the harbor is narrow, shallow, and lined with hazards. Navigable? Yes, but not an easy passage, which raises the question of whether the notice is useful or necessary.

Which brings us to the second question.

II. Is Notice 2019-7 a Hammer in Search of a Nail?

The short as well as the long answer is yes. The safe harbor in Notice 2019-7, or any safe harbor for that matter, is in my considered opinion largely unnecessary because, as I explained previously, the section 162 RREE safe harbor is much broader than the notice discloses. The robust body of case law and administrative promulgations make it unhelpful and unnecessary. Admittedly, the safe harbor may very well provide cover for the technically faint of heart. According to the notice, "Failure to satisfy the requirements of this safe harbor does not preclude a taxpayer from otherwise establishing that a rental real estate enterprise is a trade or business for purposes of section 199A." Likewise, the regulation states that "failure to meet the proposed safe harbor would not necessarily preclude rental real estate activities from being a section 162 trade or business."

What this means is that case law and administrative promulgations that deal with the question of whether rental real estate is a section 162 trade or business play a superior if not controlling role in this matter. The 70-year history of the issue can be traced to the 1949 Tax Court decision in Hazard v. Commissioner.8 The key feature of Hazard is that the court found that Hazard's single-family residential rental in Kansas City was "property . . . used in the trade or business of the taxpayer," entitling him to an ordinary loss on its sale. Hazard occupied the house as a residence until moving to Pittsburgh, after which it was rented and at the same time offered for sale for three years. Hazard was an attorney who "devoted his entire time" to his job as general counsel of a Pittsburgh company. I wish I had a nickel for every time I noted during a lecture that under Hazard, the Tax Court ruled that "with very little taxpayer involvement, even one rental unit was a trade or business."9

Hazard was stare decisis until Grier v. United States, 10 in which the Second Circuit rejected Hazard and its progeny, preferring a "broader activity" standard and finding that the 14-year long-term rental of a single residential rental to one tenant, with minimal repair activity, was an investment and not a trade or business.11

However, on facts virtually indistinguishable from Grier, the Seventh Circuit in Reiner v. United States, 12 addressed the trade or business issue differently. Quoting the Tax Court in Lagreide v. Commissioner, 13 the circuit court said, "It is clear from the facts that the real estate was devoted to rental purposes, and we [the Tax Court] have repeatedly held that such use constitutes use of the property in trade or business, regardless of whether or not it is the only property so used)." It's more than interesting that in Lagreide, the Tax Court agreed with the commissioner that the rental of a single piece of inherited residential property amounted to the operation of a trade or business regularly carried on by the taxpayer.

The IRS acquiescence to Hazard has never been revoked, even when in 1981 (on the strength of Grier) the IRS National Office audit division requested a reversal of that acquiescence. In rejecting that offer, the Office of Chief Counsel provided this revealing if terse analysis:

We read the majority of cases that have been decided since Hazard as turning upon a factual finding that a particular taxpayer was engaged in a trade or business. In the typical case, the taxpayer has offered evidence of the various activities involved in managing the rental property and the court has accepted this evidence as indicating that the taxpayer was engaged in a trade or business. Even in a case such as that described in your recent technical advice memorandum, the taxpayer undoubtedly could offer evidence of various efforts to collect unpaid rents and other activities with respect to the property. Based upon the decided cases, there is substantial doubt that the Service would prevail if such a case were litigated.

For these reasons, we question whether a change in Service position in this area is advisable. The problem that you raise is not with the legal standard applied by the courts, but with the relatively small amount of activity that the courts have found to be indicative of a trade or business (emphasis added)."14

However, the Tax Court only follows Grier in the Second Circuit and only because of the Golsen doctrine. 15

Both the preamble to the regs and Notice 2019- 7 provide that triple net leases are not eligible for the RREE safe harbor. The notice contains this description of a triple net lease: "For purposes of this revenue procedure, 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" (emphasis added).

Except for clients residing in the Second Circuit (Connecticut, New York, and Vermont), this should suggest that practitioners treat even one rental unit as a trade or business having only a small amount of activity (and perhaps even no activity if responsibility for activity resides with the taxpayer).

III. Secondary Considerations

(A) The issuance of a revenue procedure is significant for what it is not. It is not a revenue ruling. Unlike revenue rulings, revenue procedures do not purport to be an interpretation of current law. Consequently, Notice 2019-7 should be viewed not as a technical analysis but simply as a commitment that the IRS will not challenge a taxpayer that meets its safe harbor conditions. 16 In other words, it's not an examination of relevant authorities regarding when and under what circumstances a rental real estate activity will be treated as a trade or business.

(B) RREE sporting losses are subject to the same rules effectively reducing the section 199A deduction with possible loss carryover implications. The safe harbor is more like a meat cleaver than a scalpel, but it must cut both ways. Of course, it is conceivable for a taxpayer to have an RREE qualified as a trade or business and another with a loss if there is a lack of activity requisite to trade or business. As an aside, casual empiricism suggests there are more taxpayers with a net loss from rental real estate than a net profit. IRS rental real estate statistics for 2016 are interesting. Out of a total of 86,489,022 Form 1040 returns filed, 10,415,035 included Schedule E rental property information, reflecting a total of 17,560,866 rental properties. The total net profit reflected on Schedule E returns was $10,196,020,000 and the total net loss reported was $5,132,470,000, of which $1,593,020,000 was nondeductible with suspended loss carryover of $928,808,000. 17

(C) The Notice 2019-7 safe harbor may provide cover for the tax return preparer who is shy about claiming an RREE as a trade or business with net profit qualifying for the section 199A deduction. It may also provide indirect if not unintentional support for an RREE reflecting a loss.

(D) Hours worked by managers and agents count toward the 250-hour safe harbor threshold. 18

(E) Similar rental real estate properties may, at the option of the taxpayer, be combined into a single RREE.19 The aggregation rules of reg. section 1.199A-4 are not the same as those for combining rental activities into a single RREE. It is not clear what "similar" means except that commercial and residential are not similar. Perhaps section 1033 could shed some light under which properties must be "similar or related in service or use." 20

IV. Conclusion

The answers to the two questions we posed at the beginning of this article, which now seem rhetorical, are quite simply: Yes.

____________________________________________________

[1] Nathan J. Richman, Jonathan Curry, and Eric Yauch, "Treasury Issues New Passthrough Deduction Guidance," Tax Notes, Jan. 28, 2019,

p. 365.

[2] Part II.A.3.b of preamble to final reg. section 1.199A-1 through -6.

[3] Qualified Business Income Deduction (REG-107892-18).

[4] Close is not enough. Neither 679 hours nor 715 hours was sufficient to meet the 750-hour threshold of section 469(c)(7)(B)(ii). (See Todd D. Bailey Jr. v. Commissioner, T.C. Summ. Op. 2011-22; and Adeyemo v.

Commissioner, T.C. Memo. 2014-1.).

[5] See Notice 2019-7, section 3.03.

[6] Section 1.274-5T(c)(2)(ii).

[7] https://www.clientwhys.com.

[8] 7 T.C. 372 (1946), acq. 1946-2 CB 3.

[9] See also Good v. Commissioner, 16 T.C. 906 (1951) (facts

indistinguishable from Hazard).

[10] 218 F.2d 603 (2nd Cir. 1955), aff'g 120 F. Supp. 395 (D. Conn. 1954).

[11] See Pinchot v. Commissioner, 113 F.2d 718 (2 Cir. 1940); Gilford v. Commissioner, 201 F.2d 735 (2 Cir. 1953); Fackler v. Commissioner, 133 F.2d509 (6 Cir. 1943); Rogers v. United States, 69 F. Supp. 8 (D. Conn. 1946).

[12] 222 F.2d 770 (7th Cir. 1955).

[13] 23 T.C. 508 (1954).

[14] GCM 38779 (July 27, 1981).

[15] See Balsamo v. Commissioner, T.C. Memo. 1987-477 (1987), citing Golsen v. Commissioner, 445 F.2d 985 (10th Cir. 1971), aff'g 54 T.C. 742 (1970). See also, however, Murtaugh v. Commissioner, T.C. Memo. 1997-

319 (1997), distinguishing Grier by finding enough taxpayer activity to meet the Supreme Court's overarching "continuity and regularity" trade or business threshold in Commissioner v. Groetzinger, 480 U.S. 23 (1987).

[16] Rev. Proc. 93-27, 1993-2 C.B. 343, famously allows a partner who receives a profits-only interest to avoid immediate taxation if specified conditions are met, notwithstanding ample authority to the contrary.

[17] See IRS, Individual Income Tax Returns: Line Item Estimate 2016.

[18] See section 3.04 of the notice.

[19] See section 3.02 of the notice.

[20] See section 1033(a)(1) and (2).

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Philip Storrer

Philip Storrer

Philip P Storrer is a Certified Public Accountant (CPA) practice based in Discovery Bay, CA. Philip P Storrer can assist you with your tax preparation, planning, bookkeeping, and accounting needs.

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