Earlier this year, the IRS issued guidelines on the new deduction for up to 20% of qualified business income (QBI) from pass-through entities under the Tax Cuts and Jobs Act (TCJA). The IRS’s guidance attempts to clarify when the QBI deduction is available for income from rental real estate ventures. QBI deductions are only allowed for income that comes from a business, however, the term business isn’t clearly defined in legal terms, making it unclear whether real estate activities could qualify as a business. If you feel unclear about the new QBI deduction, read on.
QBI Deduction: The Basics
The QBI deduction may be available to qualifying noncorporate owners of pass-through business entities, from tax years starting in 2018 through 2025. The deduction is scheduled to be discontinued after 2025 unless Congress extends it.
With the QBI deduction, pass-through entities are considered to be:
- Sole proprietorships
- S corporations
- Single-member limited liability companies (LLCs) with a single owner that are treated as sole proprietorships
- LLCs that are treated as partnerships
There are a number of rules for the QBI deduction, including:
- The deduction is only available to individuals, estates, and trusts (all three will be referred to as “individuals” henceforth)
- The deduction doesn’t reduce an individual’s adjusted gross income (AGI); it’s essentially treated as an allowable itemized deduction
- The deduction doesn’t reduce net income from self-employment
- The deduction doesn’t reduce net investment income for purposes of the 3.8% net investment income tax (NIIT)
Several types of income are excluded from QBI; these include:
- Any income that comes from the trade or business of being an employee
- Reasonable salaries that are collected by S corporation shareholder-employees
- Guaranteed payments received by LLC partners (or LLC members treated as partners) for services rendered to partnerships or LLCs for the use of capital by partnerships or LLCs.
It’s important to note that the QBI deduction can be claimed for up to 20% of an individual’s income from qualified real estate investment trust (REIT) dividends and up to 20% of qualified income from a publicly traded partnership (PTPs).
Possible Limitations to Keep in Mind
The QBI deduction from an eligible business can’t exceed certain amounts above specified income levels. These include:
- 50% of W-2 wages paid by the business
- 25% of W-2 wages plus 2.5% of the unadjusted basis immediately after procurement of qualified depreciable property used in the business
The QBI deduction is also eliminated for income derived from specific service businesses, including accountants, doctors, lawyers, actuaries, singers, consultants, athletes, actors, investment managers, stock traders. Essentially, any business or trade where the main asset is reliant on the reputation or skill of one or more of its employees.
For the 2018 tax year, these limitations take effect once the business owner has taxable income above a certain income level. This taxable income is calculated prior to any QBI deduction and is indexed annually to account for inflation. The income-based phase-in thresholds for 2018 and 2019 are as follows:
|2018 Phase-In Range||2019 Phase-In Range|
|Married filing jointly||$315,000-$415,000||$321,400-$421,400|
|Married filing separately||$157,500-$207,500||$160,725-$210,725|
These limitations are phased in over a taxable income range of $50,000, or $100,000 for married couples filing jointly.
Additionally, an individual’s allowable QBI deduction can’t exceed less the lesser of:
- 20% of QBI from qualified businesses plus 20% of qualified REIT dividends plus 20% of qualified publicly traded partnership (PTP) income
- 20% of the individual’s taxable income calculated before any QBI deduction and before any net capital gain amount (net long-term capital gains in excess of net short-term capital losses plus qualified dividends).
The IRS’s Guidelines for Rental Real Estate Ventures
The IRS issued Notice 2019-7 to clear up when rental real estate ventures can claim the QBI deduction, which included the safe-harbor rule to help determine when a rental real estate venture can qualify as an eligible business. To be considered an eligible business under the safe harbor rule, a rental real estate venture is defined as an ownership interest in property held for the creation of rent. It may also include ownership interest in more than one property.
If a rental real estate venture doesn’t qualify for the safe-harbor rule, it may still be able to be treated as a business for QBI deduction. However, it must meet the general definition of a business as defined in the QBI regulations.
In order to qualify for the safe-harbor rule, an individual or pass-through entity must either own the interest directly or through an entity that omitted for federal tax purposes; this includes single-member LLCs that aren’t treated as separate entities apart from their owners due to tax purposes.
Taxpayers must either treat each property used for the creation of rent as a separate enterprise, or all similar properties held for the purpose of creating rents as a single rental real estate enterprise. Commercial and residential real estate must be treated as separate enterprises. Taxpayers also aren’t able to alter their treatment of properties yearly, unless there happens to be a significant change of events.
Eligibility for the Safe-Harbor Rule
For a taxpayer to be eligible for safe-harbor, they must pass and hours of service test. At least 250 of rental services must be performed each year for tax years beginning before January 1st, 2023. For tax years beginning after December 31, 2022, the 250-hour test can be met in any three of the five consecutive tax years that end with the current tax year. However, if an enterprise has been held for less than 5 years, the 250-hour test must be met for each tax year following 2022.
For all tax years following December 31st, 2018, all eligible taxpayers must keep separate income and expense records for each rental real estate venture. They must also keep contemporaneous records, including time reports, logs, or other documents to establish the number of hours spent on rental services for the venture as well as descriptions of all rental services that were performed; this includes noting the dates of the services and the name of the individual or company that performed the services.
To meet the hours of service test, qualifying rental services would include:
- Rental or lease advertising
- Lease negotiation and execution
- Verifying the information provided by tenants on their applications
- Collecting rent
- Daily management and operations
- Time spent performing routine maintenance or repairs on the rental property
- Purchasing materials for the property or repairs
- Supervision of employees or contractors
These services can be performed by property owners, employees, agents, and independent contractors. Rental services are not considered to include any type of financial or investment management like:
- Arranging financing
- Purchasing property
- Studying or reviewing financial statements or other types of operational reports
- Planning, managing or constructing long-term capital improvements
- Traveling to or from rental properties
Real estate that has been used as a residence by the taxpayer, (which would include owners or beneficiaries of a pass-through entity) for any portion of a tax year is not eligible for the safe-harbor rule, nor is real estate rented or leased under a triple net lease.
Notice 2019-7 isn’t Set in Stone but Start Following the Guidelines Now
The final rules of the Notice 2019-7 haven’t been issued yet by the IRS; however, taxpayers should still rely on these guidelines and begin complying with the recordkeeping requirements set forth by the notice. If you have any questions, your tax advisor can help you set up effective procedures to stay compliant.