Rev Proc 2020-17: Safe Harbor for Rental Real Estate

The Qualified Business Income (QBI) deduction under Internal Revenue Code Section 199A allows owners of pass-through businesses to deduct up to 20% of their qualified business income. This provision is scheduled to expire for tax years beginning after December 31, 2025. However, it created uncertainty for rental real estate owners about whether their activities would be considered a “trade or business” eligible for the deduction.

To address this, the IRS issued Revenue Procedure 2019-38. This procedure provides a safe harbor, a set of rules that, if met, allow a rental real estate activity to be treated as a trade or business for the QBI deduction. Meeting the safe harbor requirements gives taxpayers certainty in claiming the deduction.

Defining a Rental Real Estate Enterprise

A “rental real estate enterprise” is an interest in real property held for the purpose of producing rents, and it can consist of a single property or a collection of multiple properties. A taxpayer must decide whether to treat each rental property as a distinct enterprise or to group similar properties together into a single, larger enterprise. This grouping decision is important, as all subsequent qualification tests, such as the 250-hour requirement, are applied at the enterprise level.

Taxpayers are permitted to group similar properties but cannot combine different types of properties into one enterprise. Specifically, commercial and residential real estate cannot be part of the same enterprise. For example, a property owner could group all their residential apartment buildings into one enterprise and all their commercial office buildings into a separate enterprise. Once this grouping decision is made, it cannot be changed from year to year unless there is a significant change in the taxpayer’s circumstances.

Safe Harbor Qualification Requirements

To qualify for the safe harbor, a rental real estate enterprise must satisfy three conditions annually. The first is maintaining separate books and records for each designated enterprise. These records must accurately reflect the income and expenses for that enterprise. If an enterprise consists of multiple properties, the taxpayer can maintain records on a property-by-property basis and then consolidate them.

A central condition is the 250-hour requirement. At least 250 hours of “rental services” must be performed each year for the enterprise. For enterprises that have existed for at least four years, this test is met if 250 or more hours of rental services were performed in any three of the five most recent tax years. These services can be performed by the owner, their employees, or independent contractors.

The IRS specifies what constitutes a rental service. Activities that count toward the 250-hour threshold include:

• Advertising the property for rent
• Negotiating leases and verifying prospective tenants
• Collecting rent
• Managing day-to-day operations, including maintenance, repairs, and purchasing materials
• Supervising employees and contractors who perform these tasks

Conversely, activities such as arranging financing, acquiring new properties, and the owner’s travel time to and from their home to the rental property are excluded.

The final requirement is the maintenance of contemporaneous records. Taxpayers must keep detailed records that document the services performed to meet the 250-hour rule, including time reports or logs specifying the hours, dates, a description of the services, and who performed them.

Properties Ineligible for the Safe Harbor

Certain types of property are explicitly excluded from qualifying for the safe harbor, regardless of the hours spent on rental services or record-keeping. These exclusions are based on the property’s use or the nature of the lease agreement.

The first exclusion applies to real estate that is used by the taxpayer as a personal residence for any portion of the tax year. If the owner uses the property for personal purposes, as defined by the tax code, it becomes ineligible for the safe harbor for that year.

The second exclusion is for real estate rented or leased under a triple net (NNN) lease. A triple net lease is an arrangement where the tenant agrees to pay all of the property’s operating expenses, including real estate taxes, building insurance, and maintenance. Because the landlord’s management responsibilities are substantially reduced, the IRS does not permit these properties to be included in a safe harbor election.

Making the Safe Harbor Election

For taxpayers whose enterprise meets all qualifications, the final step is to formally make the safe harbor election. This process is not automatic and requires attaching a signed statement to the annual federal income tax return. The election must be made on a yearly basis for each year the taxpayer wishes to use the safe harbor.

The statement serves as a formal declaration that the taxpayer is electing to use the safe harbor and attests that all requirements of Revenue Procedure 2019-38 have been satisfied.

The statement must include a description of the rental properties being treated as a single enterprise, or a separate statement for each enterprise. It must also contain a representation, signed under penalty of perjury, that the requirements for separate books and records, the 250-hour rule, and contemporaneous record-keeping have all been met. This can be signed by the taxpayer or an authorized representative.

Implications of Not Meeting the Safe Harbor

Failing to meet the criteria of the safe harbor does not automatically disqualify a rental real estate activity from being considered a trade or business for the QBI deduction. The safe harbor is a simplified path to certainty. If an enterprise does not qualify, the determination reverts to the “facts and circumstances” test established through tax law and court cases.

Under this traditional test, a taxpayer must demonstrate that their involvement in the rental activity is regular, continuous, and substantial. This analysis is more subjective than the rules of the safe harbor. Factors considered include the number of properties rented, the day-to-day involvement of the owner or their agents, and the type of services provided to tenants.

This alternative path comes with a higher degree of uncertainty. Without the protection of the safe harbor, the burden of proof on the taxpayer during an IRS audit is greater. It requires documentation to argue that the rental activity constitutes a business operation under Section 162 of the Internal Revenue Code.