Rental property and the qualified business income deduction
Some rental property owners can claim a qualified business income deduction for their rental property. Find out how to determine when rental income is qualified business income.
Most rental real estate owners have heard about the new qualified business income deduction (QBI deduction), and many are asking, “Do I qualify for the QBI deduction?” Anytime a new federal tax law changes the rules for small businesses, these taxpayers must determine whether the changes apply to rental real property owners. The answer is far from clear and involves interpretation of many sources of law including the Code, IRS guidance, and case law.
This article will cover how the QBI deduction rules apply to rental real estate owners using the trade or business test under §162, and the new IRS safe harbor for rental real estate enterprises.
Is rental income qualified business income? It’s complicated.
The Tax Cuts and Jobs Act of 2017 (TCJA) created the qualified business income deduction, a new deduction that most business owners can take in tax years 2018 through 2025. Generally, the deduction is equal to the lesser of 20 percent of qualified business income or 20 percent of taxable income less net capital gain. Qualified business income is the net income from a qualifying business minus certain items such as capital gains.
There are many limitations and special rules that may apply when determining if a taxpayer qualifies for the qualified business income deduction. The first rule is that the taxpayer must have business income from either a sole proprietorship, an LLC taxed as a disregarded entity, a partnership, or an S corporation. These entities are unique in that they are not taxed at the entity level, rather, items of income, gain, loss, and expense flow through to and are reported on the owners’ individual returns. This means the QBI deduction is claimed on the individual owner’s return.
Commercial rental real estate ownership typically qualifies, but whether residential rental real estate income is QBI isn’t so straightforward
One area of confusion for taxpayers is whether owning rental property constitutes a “business” for qualified business income purposes. Typically, rental real estate activity is classified as passive with income and expenses reported on Schedule E (Form 1040) instead of Schedule C (Form 1040). Some rental activity may qualify as a trade or business; for example, owning only commercial rental real estate is typically considered a trade or business because of the level of management activity required of the owners. In most residential cases, the taxpayer isn’t certain if they have a trade or business because they only own one or two residential properties that do not require a lot of interaction between the taxpayer and tenants.
It is not entirely clear whether owning residential rental property qualifies as a business for the new QBID under the Code because it is not specifically mentioned. Thus, the Treasury Department and the IRS have stepped in and provided guidance in the form of regulations and notices to help these taxpayers determine if they should claim the QBI deduction or not.
To qualify for the qualified business income deduction, the taxpayer must have a trade or business
In February 2019, the IRS issued final regulations that clarified the rules for when an activity qualifies for the qualified business income deduction (QBID). The regulations define a “business” for QBID purposes as a §162 trade or business. Historically, whether an activity rises to the level of a trade or business requires an analysis of §162 to determine if expenses from an activity were deductible as business expenses or if the activity was more like an investment activity. Before the TCJA, if the taxpayer could not establish it had a §162 business, the activity was classified as an investment activity and many of the expenses were limited.
Under the traditional analysis, the Courts looked at several factors
The problem with §162 is that it does not directly define what a trade or business is, which leaves taxpayers to rely on the Tax Court’s interpretation when trying to determine if they have a §162 trade or business. Through several cases, the main tests for whether an activity qualifies developed. To qualify, the taxpayer’s scope of ownership and management must be regular, systematic, and continuous. This can be demonstrated by an owner seeking new tenants, supplying furnishings, cleaning, and otherwise preparing for new tenants.
Over time, the Tax Court provided a list of factors to make this determination.
- The manner in which the taxpayer carries on the activity.
- The expertise of the taxpayer or the taxpayer’s advisor.
- The time and effort expended by the taxpayer in carrying on the activity.
- The taxpayer’s expectation that assets used in the activity may appreciate in value.
- The success of the taxpayer in carrying on other similar or dissimilar activities.
- The taxpayer’s history of income or losses with respect to the activity.
- The amount of occasional profits, if any, that are earned.
- The financial status of the taxpayer.
- The activity has elements of personal pleasure or recreation.
For more information on each of the analysis factors, see the Insights article, When taxpayers see a side hustle, the IRS may see a hobby.
Rental activities are a bit trickier
The analysis for rental real estate activities is even more difficult because rental real estate activities are generally entered into for profit and, as any rental owner would concede, managing a rental activity doesn’t have elements of personal pleasure or recreation. For residential rental real estate activities, the relevant factors to consider:
- The manner in which the taxpayer carries on the activity, such as the way the taxpayer keeps books and records.
- The time and effort expended by the taxpayer or agent in carrying on the activity, such as the number of rental units and hours spent engaging in the activity.
- The taxpayer’s history of income or losses with respect to the activity.
Taxpayers must look at their specific facts and circumstances as a whole before making the determination that they have a business under §162 using the nine-factor test specifically the three mentioned above. For Tax Court cases about rental real estate activities, see the court cases resources provided at the end of this article.
Even if the rental real estate activity is passive, it can still be as a trade or business for QBID purposes
The Code also includes rules regarding passive losses that were enacted to prevent passive investors from using losses from the passive investment to offset taxable income from other non-passive activities, such as earned income. Rental real estate activities are typically classified as passive, which tends to lead the casual observer to infer that the activity does not constitute a business. However, passive activity rules are independent of the trade or business analysis. Where the passive activity rules require a measurement of the individual taxpayer’s activity, the trade or business analysis requires a measurement of the total activity with respect to the rental, including those hired to clean, maintain, and manage the property. So even a passive activity can be a trade or business under §162.
Certain rental activities do not qualify as a trade or business under §162
Rental activities that do not qualify as a trade or business for §162 purposes are:
- Rental for less than fair market value (FMV), aka a not-for-profit rental is not a trade or business due to the lack of profit motive;
- A single triple-net-lease (a lease agreement in which the tenant handles and pays for real estate taxes insurance, and maintenance) is not a trade or business due the extreme passive nature of the activity; and
- A vacation home used as a personal residence is not a trade or business due to the lack of profit motive.
Thus, taxpayers would have to go through case law and try to argue that enough of the factors fall in their favor for trade or business treatment, but that analysis can still be confusing. Luckily, the IRS understood there was still an issue, and the safe harbor method was born.
IRS provides safe harbor to treat rental real estate income as QBI
In response to the confusion about §162 status, the IRS issued Notice 2019-07 which provides a safe harbor for taxpayers to treat their rental property ownership as a business for QBID purposes. To claim the safe harbor, a taxpayer must qualify as a “rental real estate enterprise” and satisfy the other requirements detailed in the notice. If all requirements are met, a taxpayer’s rental real estate activities will be treated as a qualified trade or business only for QBID purposes. It is important to note that if a taxpayer does not meet all the requirements for the safe harbor, that does not mean the QBID is unavailable, but, rather, the taxpayer can qualify using the §162 analysis discussed above.
The Notice 2019-07 safe harbor requirements to qualify as a rental real estate enterprise
Under the safe harbor, a “rental real estate enterprise” is an interest in real property held for collecting rents. The interest can be for a single property, or a collection of multiple properties. The safe harbor clarifies that when grouping properties, a taxpayer cannot include residential and commercial real estate in the same enterprise, and the taxpayer must continue to keep the same groupings year to year unless there is a significant change in the facts and circumstances. The final requirement for an enterprise is that the taxpayer must hold the interest in the property either directly or through a pass-through entity such as a partnership or S corporation.
Example: John directly holds an interest in three residential rental properties in Kansas City, Missouri. He is also the sole member in an LLC that has a warehouse used in another business. John could either treat all four properties as separate rental real estate enterprises or choose to group the three residential properties into a single enterprise. The warehouse cannot be grouped with the residential properties since it is classified as commercial property. No matter what method he uses, John will have to keep using that method year over year.
Real estate that is used as a personal residence under the vacation home rules in §280A, or property rented under a triple net lease will not qualify for safe harbor treatment. For the safe harbor, a triple net lease includes a lease agreement that requires a tenant or lessee to pay all or a portion of the taxes, fees, and insurance, and to be responsible for maintenance activities for a property in addition to rent and utilities.
Three additional safe harbor requirements under Notice 2019-07
There are three additional requirements that must be satisfied to qualify for the safe harbor. If the requirements are met, the taxpayer must attach a signed statement to their return each year stating the activity qualifies for the safe harbor. The additional requirements are that the taxpayer must:
1. Maintain separate books and records to reflect income and expenses for each rental real estate enterprise;
2. Perform 250 hours of rental services with respect to the enterprise during the year; and
3. Maintain contemporaneous records, including time reports, logs or similar documents for the following:
- Hours of all services performed;
- Description of all services performed;
- Dates on which such services were performed; and
- Who performed the services.
For the purposes of the safe harbor, rental services include the following:
- Advertising to rent or lease the real estate;
- Negotiating and executing leases;
- Verifying information contained in prospective tenant applications;
- Collection of rent;
- Daily operation, maintenance, and repair of the property;
- Management of the real estate;
- Purchase of materials; and
- Supervision of employees and independent contractors.
It is important to note that taxpayers should evaluate whether using the safe harbor is in their best interest based on their tax situation. For example, if most of the taxpayer’s rental properties produce losses it may be beneficial to exclude them from the safe harbor because taxpayers must reduce profits from qualified businesses by losses from others when calculating QBID.
Example continued: John meets all the requirements listed above for his three residential properties, but not the warehouse. To claim the QBID for the residential rental property income, he will have to attach a statement to his return stating the safe harbor requirements are met. For the warehouse, John will not be able to use the safe harbor, but, depending on the facts and circumstances, he could treat it as a §162 business, if it qualifies.
Whether a rental real estate activity qualifies for the QBID can be a complicated determination. Regardless of the situation, taxpayers with rental real estate activities should consult a tax advisor before making any tax planning decisions.
HRB tax professionals, click to login and access Tax Research Center resources:
- Qualified Business Income Deduction – Part 7: Residential Rental Activities
- When does a rental real estate activity qualify as a trade or business for QBID purposes?
Rental real estate as a trade or business cases:
- Comm’r. v. Groetzinger, 107 S. Ct. 980 (1987) (hobby vs. business factors)
- Curphey v. Comm’r, 73 TC 766 (1976) (investment vs. business factors)
- Jephson, 37 BTA 1117 (1938) (taxpayer who purchased home but failed to rent still engaged in business)
- Anderson v. Comm’r, 250 F.2d 242 (1957) (taxpayer must maintain adequate books of activity)
- Union National Bank of Troy,195 F.Supp. 382 (1961) (finding the minimal nature of taxpayer’s activity meant the activity was an investment or capital asset held for production of income)
- Jackson, TC Memo 1975-265 (loss on real estate treated as capital loss even though taxpayer held for sale, he wasn’t in the business of selling and didn’t acquire the property for use in a rental business)
- Grier v. U. S., 120 F.Supp. 395 (1954) (property held for investment rather than use in a trade or business based on lack of broader activities to demonstrate the contrary)