The Tax Cuts and Jobs Act (TCJA) created a significant new tax deduction for qualified business income (QBI) for so-called “pass-through” entities for 2018 through 2025. But it also created uncertainty about whether owners of rental real estate were eligible for the deduction. Recent IRS guidance addresses this gap with a proposed safe harbor that allows certain real estate enterprises to qualify as a business for purposes of the deduction.
Claiming the deduction
Qualifying pass-through entities, including partnerships, limited liability companies (LLCs), S corporations and sole proprietorships, are generally allowed to deduct up to 20% of QBI. QBI means the net amount of income, gains, deductions and losses (excluding reasonable compensation, certain investment items and payments to partners for services rendered).
A wage limit begins phasing in if your taxable income for 2019 exceeds $160,700 for single people, $321,400 for married people who file jointly, or $160,725 for married people who file separately. Under the limit, your deduction can’t exceed the greater of 50% of the business’s W-2 wages or 25% of the W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of qualified business property.
In partnerships or S corporations, each partner or shareholder is treated as having paid W-2 wages for the tax year in an amount equal to his or her allocable share of the W-2 wages paid by the business for the tax year. The UBIA of qualified property generally is the purchase price of tangible depreciable property the business held at the end of the tax year.
The application of the wage limit phases in for individuals with taxable income exceeding the threshold amount, over the next $100,000 of taxable income for married individuals filing jointly or the next $50,000 for other individuals. It phases in completely when taxable income for 2019 exceeds $210,700 for single people, $421,400 for married people who file jointly and $210,725 for married people who file separately.
This deduction generally can’t exceed 20% of your taxable income less any net capital gains. So, for example, if the QBI for a married couple with no net capital gains is $400,000 and their taxable income is $300,000, the deduction is limited to 20% of $300,000, or $60,000. There is a more involved calculation if 20% of the QBI is less than taxable income. The deduction is 20% of the QBI plus 20% of qualified REIT dividends plus 20% of publicly traded partnership income, with the total subject to the 20% taxable income limit.
The QBI deduction applies to taxable income and doesn’t factor in when computing adjusted gross income (AGI). It’s available for both itemizing and nonitemizing taxpayers, as well as those paying the alternative minimum tax.
Qualifying for the safe harbor
Owners of rental real estate received welcome news when the IRS issued final regulations for the QBI deduction along with additional guidance. The guidance (IRS Notice 2019-07) details the proposed safe harbor that would allow certain real estate enterprises to claim the deduction. Taxpayers can rely on the safe harbor until a final rule is issued.
Generally, the safe harbor provides that eligible rental businesses (see “What counts as a rental real estate enterprise?”) can claim the deduction if:
- Separate books and records are kept to reflect income and expenses for each rental real estate enterprise,
- For taxable years through 2022, at least 250 hours of rental services are performed each year for the enterprise, and
- For tax years after 2018, the taxpayer maintains contemporaneous records showing the income and expenses, the hours of all services performed, the services performed, the dates they were performed and who performed them.
For taxable years after 2022, the 250 hours of rental services may be performed in any three of the five consecutive taxable years that end with the taxable year (or, for enterprises held less than five years, in each year).
The hours-of-services requirement may be satisfied by work performed by owners, employees or contractors. Qualifying work includes maintenance, repairs, rent collection, expense payment, negotiating and executing leases, and efforts to rent out property. Investment-related activities — for example, arranging financing, procuring property and reviewing financial statements — don’t qualify.
The safe harbor isn’t available for property leased under a triple net lease that requires the tenant to pay all or some of the real estate taxes, maintenance, and building insurance and fees. It also doesn’t apply to property the taxpayer uses as a residence for any part of the year.
Just an appetizer
The QBI deduction is just one of many potential perks in the TCJA for real estate businesses. But numerous rules and restrictions apply. Fortunately, your financial advisor can help you navigate the details.
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What Counts as a Rental Real Estate Enterprise?
The safe harbor for being treated as an eligible business for qualified business income (QBI) deduction purposes is available only to “rental real estate enterprises.” The IRS notice defines this as an interest in real property held to produce rents and says it may consist of an interest in multiple properties.
The taxpayer — whether an individual, a partnership or an S corporation — must hold the interest directly or through a disregarded entity (an entity that isn’t considered separate from their owners for income tax purposes, such as single-member limited liability companies). Taxpayers can either treat each property as a separate enterprise or treat all similar properties as a single enterprise. You can’t, however, treat commercial and residential real estate as part of the same enterprise. And you can’t change the treatment from year to year absent a significant change in circumstances.