The Tax Cuts and Jobs Act of 2017 created the section 199A qualified business income (QBI) tax deduction, which is a 20% tax deduction for non-corporate business income. Most types of business income other than C corporation income qualifies for this deduction. But rental income can also qualify if certain conditions are met.
The QBI deduction isn’t beneficial to rental properties that are already at a tax loss. So if your taxable income is already negative (thanks to depreciation), then you won’t benefit from trying to qualify for the QBI deduction. But it is beneficial if you have a taxable income from your rental properties. And if your rentals qualify as a trade or business, you may need to report the tax loss as part of your QBI calculations even if it isn’t to your benefit.
Capital gain when you sell a property isn’t eligible for the QBI deduction, but section 1245 recapture is. So there may be some benefit to qualifying for QBI when you sell a property in some cases, but mostly it’s beneficial just to the rental income.
How to Qualify
The QBI deduction is defined in section 199A of the tax code. Treasury regulation § 1.199A-1(b)(14) specifies “an activity qualifies for §199A as long as it is a §162 trade or business.” So then you have to determine if your rental activity qualifies as a §162 trade or business. There isn’t a well-defined test to make that determination, so it’s based on a number of factors. The IRS does offer a “safe harbor” where they will consider the rental property as qualifying if you meet the terms of the safe harbor. However, the safe harbor is relatively challenging to qualify for, and you can still be eligible for the deduction even if you don’t necessarily meet the safe harbor criteria. Let’s dig into the specifics.
199A Safe Harbor for Rental Real Estate
We’re providing information on the safe harbor as a reference; however, in reality, few taxpayers use the safe harbor because it is much easier to qualify without it. Most taxpayers can ignore this section and skip to the “Qualifying Without Using the Safe Harbor” section below.
IRS rev. proc. 2019-38 offers a safe harbor, where the IRS will consider the rental to be a qualified trade or business if you meet their specific terms, which includes all the following:
- The property can’t be used as your residence at all, it can’t be leased under a “triple net lease”, and it can’t be rented to your own trade or business.
- Separate “books and records” tracking the income/expenses for each rental property.
- For rentals you’ve had less than 4 years, you or an employee/agent/contractor must spend at least 250 hours/year of your time doing work for the property.
- For rentals you’ve had more than 4 years, you or an employee/agent/contractor must spend at least 250 hours/year of your time doing work for the property in any 3 of the last 5 years (including the current tax year).
- You must keep a log of hours spent on it, including the time spent, a description of services performed, the dates, and who performed the services. If the work is done by an employee or contractor, you must also record how much they were paid for their time. This log requirement only applies to tax years 2020 and later (but you still have a burden of proof for time spent in earlier years).
- A statement must be attached to the timely filed (not overdue) tax return with a statement requesting the safe harbor and a description of the rental properties it is used for.
The IRS guidelines have more information about all the specifics, including the types of hours that count and don’t count.
If you have multiple rental properties, you can choose to group properties together into “rental real estate enterprises,” so that they can meet the hours requirement as a group if they don’t qualify separately. Residential and commercial properties can’t be grouped together (and short-term rentals with an average stay of 30 days or less would be considered commercial). The grouping can’t be ungrouped in future tax years unless the circumstances of the rentals change. This QBI safe harbor grouping is unrelated to other grouping elections such as section 469 grouping.
If that sounds like a lot of effort to qualify for the safe harbor, that’s because it is. In particular, maintaining a log of the hours spent with all the required information takes a fair amount of work. It’s great if you qualify using the safe harbor, but thankfully you can also qualify for the QBI deduction even if you don’t necessarily qualify using the safe harbor.
Qualifying Without Using the Safe Harbor
You can qualify for the QBI deduction with a rental even if you don’t meet all the requirements of the safe harbor. The tax code just requires that the rental be considered a trade or business under section 162 of the tax code, and most rentals do qualify.
There mostly aren’t specific rules or qualifications about how a rental can qualify as a trade or business. They just consider all the facts and circumstances to make a determination. Here are some general guidelines:
- The IRS 199A FAQ says “the taxpayer must be actively involved in the activity with continuity and regularity and the primary purpose for engaging in the activity must be for income or profit.”
- The supreme court’s definition is “the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit. A sporadic activity, a hobby, or an amusement diversion does not qualify.”
- You likely qualify if you, or an employee or contractor working under you, are consistently involved in the operations of the rental.
- The real estate professional status doesn’t automatically make your rentals qualify for QBI. REPS status is mostly unrelated to QBI.
- You don’t need to reach the standard of “material participation” to qualify for QBI (but if you qualify as materially participating, then almost certainly it qualifies for QBI). A property can be considered “passive” under the section 469 tax code, but still be considered to be a section 162 trade or business qualifying for QBI.
- A “triple net” (“NNN”) lease arrangement most likely does not qualify for QBI due to the lack of owner involvement in that type of arrangement.
- You can’t live in the property as your residence for any part of the year.
- The property must be located in the US.
- The property may be owned in your own name, an LLC, a partnership, or an S corporation. It just can’t be owned under a C corporation.
- A property can also qualify if it is rented to a business that is also owned by the taxpayer (owning 50% or more of the property and of the business).
It’s worth mentioning that if you qualify for QBI, you also meet the qualifications to require that you issue 1099-NEC forms when you pay for services for the property.
