Now that tax season is here, I’m sure you’re looking for ways to write off as many expenses as possible, including those related to owning real estate. While a good tax accountant or attorney can help you uncover these sometimes-hidden tax benefits related to rental property ownership, so can a good property manager.
Specifically, a property manager can assist with a law that will enable you to keep 20% of your rental income completely tax free: The Qualified Income Business deduction.
The qualified business income deduction (QBI) is a tax deduction introduced as part of the Tax Cuts and Jobs Act (TCJA) of 2017. Also known as the Section 199A deduction or the 20% Pass-Through Deduction, the QBI lets owners of pass-through businesses deduct upwards of 20% of their qualified business income from a qualified trade or business if the owners meet certain thresholds.
Figuring out if you qualify for the QBI deduction can be complicated because the proposed regulations rest on a tax law question that doesn’t have a definitive answer: is owning property to generate income via rent collection a business or an investment? Rather than directly answering this question, the IRS provides a set of criteria to qualify for the deduction. Meeting these criteria means that the individual(s) or entity puts in enough of a particular type of work to qualify for the QBI deduction.
Given how complicated the QBI deduction is, consulting with a real estate professional is advised. Mynd’s property management services can be particularly helpful because of how accurately they can document all the work it takes to maintain your rental properties.
Who Qualifies for the New Tax Law?
QBI is the net amount (meaning the amount after all deductions) of eligible income, gain, deduction, and loss stemming from a qualified U.S. trade or business. Only taxable income is included in QBI.
What doesn’t count as QBI?
- Income from businesses located outside of the U.S.
- Services performed as an employee
- Capital gains and loses
- Shareholder wage
- Certain dividends
- Interest income
Who is eligible for the QBI deduction?
Taxpayers can make the QBI deduction whether they use Schedule A for itemized deduction or take the standard deduction. The QBI deduction can be taken in addition to one or the other of the former, and is subject to limitations based on:
- The type of trade or business
- The taxpayer's taxable income
- The amount of W-2 wages paid with respect to the qualifying trade or business
- The unadjusted basis of qualified property held by the trade or business
What counts as a qualified trade or business?
- The taxpayer’s involvement must be continuous and regular.
- The primary purpose of the activity must be for income or profit.
What’s a Specified Service Trade or Business (SSTB), and does it qualify for the QBI deduction?
A specified service trade or specified service business (SSTB) refers to trades or businesses where the principal asset is the reputation or skill of one or more employees in the following fields.
- Actuarial science
- Performing arts
- Financial services
- Investment management
- The full 20% QBI deduction is available to
- Single filers with a taxable income less than but not equal to $157,500
- Married couples filing jointly with a taxable income less than but not equal to $315,000
- Partial deduction for SSTBs are available for:
- Single filers with a taxable income of $157,500 - 207,500
- Married couples filing jointly with a taxable income of $315,000 - $415,000
- No deduction is available to
- Single filers with a taxable income is greater than $207,500.
- Married couples filing jointly with a taxable income is greater than $415,000
What is a pass-through business?
The term “pass-through” is rooted in how these entities are taxed. While a C corporation pays corporate federal income taxes, a pass-through business’s profits “pass-through” to the business owner’s income tax return. To put it another way, these businesses don’t file taxes; their owners do. Tax advantages such as the QBI are why knowing how to choose the right legal entity for your real estate investment is important.
Types of pass-through business include:
- Sole proprietorship
- S corporation
- Real estate investment trusts (REITs)
- Publicly traded partnerships (PTPs)
How much is the QBI deduction?
The deduction is usually the lesser of the following two options:
- 20% of QBI plus 20% of qualifying REIT dividends and qualifying PTP income.
- 20% of taxable income calculated before the QBI deduction minus net capital gains.
If your business is not an SSTB, but you’re a single filer with a taxable income greater than $207,500 or married filing jointly with a taxable income greater than $415,000 your QBI deduction is limited to the greater of:
- 50% of your share of W-2 income paid out in the business
- 25% of your share of W-2 income page out of the business, plus 2.5% of qualified property.
What is qualified property?
Qualified property is tangible, depreciable property that’s not yet at the end of its depreciable life. Property tends to have a depreciable life of 10 years, but, in real estate, depreciable life may be as high as 39 years.
What is a rental real estate enterprise (RREE), and does it qualify for the QBI?
A rental real estate enterprise (RREE) refers to holding an interest in one or more real properties to generate income through rent collection. An employee of an RREE does not qualify for the QBI deduction. To get the QBI deduction, you must hold interest in an RREE.
Your RREE must have been in existence for at least four years and meet the 250-hour requirement for any three of the five years that end with the taxable year in question.
So long as it meets the criteria that determine eligibility for the QBI deduction, your RREE should qualify for the QBI.
What is property interest?
“Property interest” is a technical term. It describes the extent of an individual’s or entity’s stake in the property. It refers to:
- Percentage of ownership
- Length of ownership
- Right of survivorship
- This is about jointly owned property. It means that if one owner dies, the surviving owner automatically receives the deceased owner’s percentage of the property.
- Rights to transfer property
- This is the property owner’s right to give away some property rights while still retaining ownership.
- Rights encumber property
- This means that an individual or entity has a nonpossessory stake in a property. Examples include liens, encroachments, leases, etc.
How must property be treated to qualify for the QBI deduction?
- Each property must be treated as a separate enterprise or bundled together with all properties of a similar type treated as a single enterprise. You cannot change whether you categorize your properties as an enterprise individually or collectively unless there’s a significant change in your circumstances.
- Commercial and residential real estate can’t be a part of the same RREE.
- When it comes to mixed-use property, which contains both residential and commercial facets, one has the option of treating the property as a single RREE or dividing the property into separate residential and commercial interests.
What is “safe harbor” and what does it have to do with QBI?
“Safe harbor” is an honorific that allows an eligible taxpayer or entity to avoid legal or financial liability after certain criteria are met. When regulatory agencies have rules and regulations deemed prohibitively cumbersome or confusing, these agencies may offer safe harbor as a more accessible route of achieving the same end.
When the QBI was initially introduced, there was confusion about whether or not RREEs were eligible. So, the IRS offered safe harbor so RREEs could qualify for the QBI deduction.
What are the safe harbor conditions for the QBI?
- Separate books and records must be kept for each RREE.
- Two hundred fifty or more hours of rental services for each RREE must be performed. That includes:
- Screening tenants
- Collecting rent
- Operation, repairs, and maintenance
- Management of the real estate
- Buying materials
- Supervising employees and independent contractors
- Rental services that do not qualify:
- Financial or investment management, such as financing
- Studying and reviewing financial statements or reports
- BAR improvements (Regulation Sec. 1.263(a)-3(d) of the IRS)
- Betterment: changes that are solutions to problems that predated your purchase of the property or changes that made the property bigger or better.
- Adaptation: When your property is used in a way other than how it was intended to be used when first bought.
- Restoration: Making changes to your property so that it’s “like new.” If you’re making an improvement that deals with disrepair that’s already cost you money.
- Traveling to and from your real estate.
- For 2019 and after, taxpayers must maintain contemporaneous records documenting:
- Hours of service
- Services performed
- Dates of service
- Who performed the service
When submitting for the QBI deduction, you must include a statement with your tax return indicating that you’ve met all the safe harbor requirements. While the statement can be signed, it doesn’t have to be. The signature on the tax return itself will suffice.
The statement must include:
- The address and rental category of every property.
- A description of all the properties included in the RREE.
- A description of all the properties acquired and transferred during the tax year.
- A notice that all the safe harbor requirements have been met
Why did the QBI deduction require a safe harbor?
If you’re a rental property investor, you can file with either Schedule E or Schedule C. The IRS outlines the use of each form.
- Schedule E is used,” to report income or loss from rental real estate, royalties, partnerships, S corporations, estates, trusts, and residual interests in real estate mortgage investment conduits (REMICs).”
- Schedule C is used “to report income or loss from a business you operated or a profession you practiced as a sole proprietor. An activity qualifies as a business if:
- Your primary purpose for engaging in the activity is for income or profit.
- You are involved in the activity with continuity and regularity.”
This gets at the heart of the matter: is owning real estate to collect rent an investment or a business? Or perhaps some mixture of the two, or even a third, fourth, or fifth option? Rather than render a verdict that might have sweeping consequences, the safe harbor makes it possible for real estate investors to make use of the QBI deduction without an answer to this question being necessary.
What is a self-rental, and does it qualify for the QBI deduction?
Self-rental is when you, the owner, rent property to your own business. The final regulations of the QBI deduction contain a provision that makes self-rentals eligible so long as they are commonly controlled, which means that an individual or entity owns at least 50% of both the rented property and the business being rented to. The owner must be an individual or pass-through entity. The owner cannot be a C-corporation.
What is a triple net lease, and does it qualify for the QBI deduction?
Usually, real estate taxes, fees and insurance, and maintenance are the landlord's responsibility. In a triple net lease, known as a triple-Net or NNN, the tenant pays some or all of the three.
As a result, a triple net lease may have a hard time qualifying for the QBI deduction because so much of the work that a triple net lease entails is not eligible for the deduction:
- Financial or investment management
- Studying and reviewing financial statements or reports
Additionally, in a triple net lease, the tenant may end up having more responsibilities than the owner, which would mean that the owner’s involvement wouldn’t be “continuous and regular.”
However, a triple net lease doesn’t necessarily preclude eligibility for the QBI deduction. The owner would simply have to meet all the safe-harbor criteria.
Are REITS or PTPs eligible for the QBI deduction?
The QBI deduction is usually not applicable to passive investment income such as dividends, interest, capital gains. However, upwards of 20% of combined qualified REIT dividend and qualified PTP income may be eligible for the QBI deduction for individuals and some trusts and estates.
What forms do I need to file for the QBI deduction?
- Form 1040 Instructions are used if your taxable income before the QBI deduction is under $157,500 for single filers and $315,000 if you’re a married couple filing jointly.
- IRS Publication 535 is used if your pre-QBI deduction taxable income is greater than the above income threshold.
- Form 8995: Beginning with 2019 returns filed in 2020, business owners who claim the QBI deduction will have to be attached to their returns. Form 8995 contains the same computation found in the 2018 Form 1040 Instructions.
Does the QBI deduction expire?
Yes, without congressional action, the QBI deduction expires in 2025.
20% is a lot of savings, and the QBI deduction makes you work for it in more ways than one. You have to work enough hours to qualify for the deduction, and it takes work to determine whether or not you qualify for the deduction.
Luckily, a property management company like Mynd can make earning the QBI deduction savings a breeze. To find out how Mynd can help you save upwards of 20% on your taxable income!
To find out how Mynd can help you reduce some of your tax burden, contact us today.