Deciphering the Qualified Business Income Deduction as it Relates to Rental Property

By September 9, 2019 July 29th, 2020 Real Estate, Tax
Row of Buildings in New York - Deciphering the Qualified Business Income Deduction as it Relates to Rental Real Estate

The passage of the Tax Cuts and Jobs Act (TCJA) in December 2017 instituted a new section of the Internal Revenue Code (IRC). Section 199A introduced the 20% qualified business income (QBI) deduction for certain sole proprietors and owners of pass-through entities.

However, since the inception of IRC § 199, frustration has grown regarding the qualification of rental property. From the outset, the rules were silent and ambiguous on whether rental activity qualifies for the deduction. In response to initial frustration, the Internal Revenue Service (IRS) and U.S. Department of the Treasury released proposed regulations in August 2018. Yet again, though, the questions surrounding rental activity remained unanswered.

The final regulations issued in January 2019, once again, failed to provide clarity to the rental property situation. However, the IRS and Treasury concurrently distributed Notice 2019-07 “Section 199A Trade or Business Safe Harbor: Rental Real Estate”. The Notice offers well-defined guidelines to the Section 199A relation specifically to rental property.

What’s in this article?

What makes up Qualified Business Income?

According to the IRS, Qualified Business Income is “the net amount of qualified items of income, gain, deduction and loss from any qualified [domestic] trade or business. Only taxable items included in taxable income are counted.”

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What is the Qualified Business Income deduction?

The Qualified Business Income deduction, also known as the Section 199A (§ 199A) deduction or QBI deduction, offers a new tax deduction for qualified business owners under the TCJA.

Generally, the Qualified Business Income deduction:

  • Is for business owners;
  • Can be up to 20% of qualified business income;
  • Can be taken in addition to the usual allowable business expense deductions;
  • Is for pass-through businesses (sole proprietors, LLC owners, partners, some trusts, and S corporation owners), but NOT for corporations;
  • May be limited or not applicable to higher-income individuals;
  • Is in effect for tax years 2018 through 2025.

The official IRS definition, including information about the second part of Section 199A – the REIT/PTP Component – is here.

A number of factors determine your eligibility for the Qualified Business Income deduction:

  1. Business type
  2. Amount of net income from the business for that year. Some business income is not included.
  3. Your total taxable income as a taxpayer for the year. Certain thresholds dictate your eligibility and deduction amount.

What business types qualify for the Qualified Business Income deduction?

Per the final regulations, only pass-through entities qualify for the Qualified Business Income deduction. With pass-through businesses, the income from the business is taxed on the owner’s personal tax return. For that same reasoning, corporations do not qualify, as the corporation’s income is taxed separately from the business owner.

Pass-through entities include:

  • Sole proprietors and single-owner LLCs filing federal income taxes on Schedule C
  • Partnerships and multiple-member LLCs filing partnership returns
  • S corporations filing Form 1120-S

What income type is allowed? Are there any limits or exclusions?

Your Qualified Business Income deduction is dependent upon the amount of qualified business income, meaning the business net income for the year. For this reason, the following items do not count towards total QBI:

  • Business income from beyond the U.S.
  • Income from business investments
  • W-2 income (wages) paid to an S corporation owner
  • Guaranteed payments to a partner

Other types of business income are also excluded for the sake of the QBI deduction, but may still qualify for other deductions.

Furthermore, the Section 199A deduction can be limited by the amount of wages paid to employees and the cost of some property owned and recently purchased by the business. This is called “unadjusted basis immediately after acquisition (UBIA).”

In addition, the QBI deduction is solely for business income for federal income tax purposes. It does not include a deduction from self-employment tax.

What is the total taxable income threshold?

In order to qualify for the full deduction, taxable income must not exceed $157,500 for a single person or $315,000 for married couples who file jointly. Taxable income includes business income, as well as other sources such as employment income and capital gains. As taxable income surpasses the limits, the laws restrict or eliminate the available QBI deduction.

Additionally, certain business types known as Specified Service Trades or Businesses (SSTB’s) may not qualify for the full QBI deduction if the owner’s income exceeds the limits. SSTB’s are businesses involving the performance of services, such as health, law, accounting, performance arts, consulting, athletics, and financial services or investing. More simply, trades or businesses founded on the reputation or skill of one or more employees or owners, puts the QBI deduction at risk.

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How does the Qualified Business Income deduction impact rental property?

With the issuance of the Qualified Business Income deduction final regulations, the question regarding the classification of rental property activity took center stage. Is it considered a trade or business for tax purposes, or simply an investment? The answer is crucial. However, until the recent Notice 2019-07, the answer was anything but clear and obvious.

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How do I know if my rental property qualifies for the Qualified Business Income deduction?

1. IRC § 162 Trade or Business

Initially proposed regulations offered ambiguous rules regarding rental property activity qualifications under the “trade or business” stipulation. However, the final Section 199A regulations point to the Section 162 trade or business clause as a sufficient definition. Additionally, the trade or business must be profit-motivated and require substantial, regular and continuous activity. Therefore, any irregular activity does not qualify. Certain factors to determine whether the rental real estate activity qualifies under Section 162 are:

  • Type of property rented (commercial v. residential);
  • Number of properties rented;
  • Owner’s (or owner’s agents’) day-to-day involvement;
  • Types and significance of any ancillary services provided under the lease; and
  • Terms of the lease (e.g., a net v. traditional lease and short-term v. long-term lease)

The definition in the final regulations provides no further clarity than the originally proposed regulations. The ambiguity still existed. However, in response to the outpouring of questions and concerns, the issuing federal agencies admitted that whether an activity meets the level of an IRC § 162 trade or business is inherently factual. The agencies further explain that taxpayers may have difficulty discerning whether their rental real estate activity sufficiently satisfies the requirement.

2. Renting Property to a Related Party

Under specific circumstances, a rental activity that rents to a related person is classified as a trade or business for Qualified Business Income purposes. The activity must involve renting or licensing the property to an individual or pass-through entity that is commonly controlled. This means that the same person or group of persons owns at least 50% of the rental activity and the related trade or business. Furthermore, the related party cannot be a C corporation.

Please note that income derived from renting to an SSTB – which does not qualify as a trade or business under Section 199A – is treated as income from an SSTB and may be partially or completely excluded from QBI. Treatment of the SSTB income is dependent upon the taxpayer’s taxable income (see above).

3. Proposed Safe Harbor

Following relentless calls for greater clarity regarding rental real estate activities, the IRS and Treasury released Notice 2019-07. The Notice provides proposed safe harbor requirements for rental real estate activity to qualify as a trade or business solely for the purposes of § 199A deductions. It is important to remember that if the activity does not satisfy safe harbor requirements, it may still be treated as a trade or business if it meets the definition outlined in § 162 or meets the related party requirements (see above).

The safe harbor applies to individuals or relevant pass-through entities which directly hold interest in rental property or indirectly through a disregarded entity. Some of the notable safe harbor provisions are as follows:

  • Separate books and records must be maintained to reflect income and expenses for the rental real estate activity;
  • For taxable years beginning prior to January 1, 2023, owners, employees, agents and/or independent contractors must perform at least 250 hours each year with respect to the rental real estate activity;
  • There must be contemporaneous records – including time reports, logs, or similar documents of services performed (see the following list for specific required information) for tax years beginning on or after January 1, 2019;
    • Hours of all services performed
    • Description of services performed
    • Dates on which such services were performed
    • Who performed the services
  • Real estate rented under a triple net lease in which the tenant or lessee pays for taxes, fees, insurance and maintenance is not eligible;
  • Real estate activities are not considered a trade or business if real property is used as a residence as defined in Section 280A (i.e., it is used personally by an owner for longer than 14 days or 10% of the number of days during the year in which the property is rented at a fair rental); and
  • Taxpayers must attach a statement signed under penalties of perjury to their tax return to indicate satisfaction of safe harbor regulations.

What activities count under the safe harbor rules?

Rental services, for purposes of the revenue procedure, including the following:

  • Advertising to rent or lease the real estate
  • Negotiating and executing leases
  • Verifying information contained in the prospective tenant applications
  • Rent collection
  • Daily operation, maintenance, and repair of property
  • Management of the real estate
  • Purchase of materials
  • Supervision of employees and independent contractors

What activities do not count under the safe harbor regulations?

Any time devoted to the following activities does not constitute rental activities and cannot count towards the 250-hour requirement:

  • Arranging financing
  • Procuring property
  • Assessing and reviewing financial statements or reports on operations
  • Planning, managing, or constructing long-term capital improvements
  • Time spent traveling to and from the rental property

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