The IRS recently issued guidance 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). It aims to clarify when the QBI deduction is available for income from rental real estate enterprises.
Defining a Business under the QBI Regulations
What does the term “trade or business” mean for QBI deduction eligibility purposes? It refers to an activity that’s a trade or business under Section 162 of the Internal Revenue Code, which allows deductions for business-related expenses.
Unfortunately, determining what constitutes a trade or business for Sec. 162 purposes requires parsing old court decisions. Under case law, a rental activity will generally be a Sec. 162 trade or business unless the property owner just collects the rent without doing much else, such as under a triple net lease arrangement.
However, IRS regulations stipulate that the licensing of tangible or intangible property that doesn’t qualify as a Sec. 162 trade or business can still be treated as a trade or business for QBI deduction purposes. How? The property must be rented or licensed to a trade or business conducted by the individual or a pass-through entity that’s commonly controlled.
The QBI deduction is allowed only for income from a business. But the term “business” isn’t defined in the statutory language. When the TCJA became law, it was unclear whether a rental real estate activity could count as a business for QBI deduction purposes. Here’s how the new guidance helps clarify the issue.
Basics of the QBI Deduction
The QBI deduction is potentially available to eligible noncorporate owners of pass-through business entities for tax years beginning in 2018 and extending through 2025. The deduction is scheduled to disappear after 2025, unless Congress extends it.
For QBI deduction purposes, pass-through entities are defined as:
- Sole proprietorships
- S corporations
- Single-member limited liability companies (LLCs) with one owner that are treated as sole proprietorships for tax purposes
- LLCs that are treated as partnerships for tax purposes.
The QBI deduction is complex and involves a number of rules.
For example, the deduction:
- Is only available to individuals, estates, and trusts. (We refer to all three as “individuals” to keep things simple.)
- Doesn’t reduce an individual’s adjusted gross income (AGI). In effect, it’s treated the same as an allowable itemized deduction.
- Doesn’t reduce net earnings from self-employment for self-employment tax purposes.
- Doesn’t reduce net investment income for purposes of the 3.8% net investment income tax (NIIT).
Income from the trade or business of being an employee doesn’t count as QBI. Also excluded from QBI are reasonable salaries collected by S corporation shareholder-employees and guaranteed payments received by partners (or LLC members treated as partners for tax purposes) for services rendered to partnerships (or LLCs) or for the use of capital by partnerships (or LLCs).
The QBI deduction can also 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 publicly traded partnerships (PTPs).
Above specified income levels, the QBI deduction for income from an eligible business can’t exceed the greater of:
- 50% of W-2 wages paid by the business, or
- 25% of W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition of qualified depreciable property used in the business.
In addition, the QBI deduction is phased out for income from specified service businesses. Examples include doctors, lawyers, accountants, actuaries, actors, singers, consultants, athletes, investment managers, stock traders and any other trade or business where the principal asset is the reputation or skill of one or more of its employees.
For 2018, these limitations are phased in when the business owner has taxable income (calculated before any QBI deduction) above certain levels. These income limits are indexed annually for inflation. Here are the income-based phase-in thresholds for 2018 and 2019:
- 2018 Phase-In Range
- 2019 Phase-In Range
- Married filing jointly
- Married filing separately
- Other taxpayers
These limitations are phased in over a taxable income range of $50,000, or $100,000 for married couples who file joint returns.
Under another limitation, an individual’s allowable QBI deduction can’t exceed the lesser of:
- 20% of QBI from qualified businesses plus 20% of qualified REIT dividends plus 20% of qualified publicly traded partnership (PTP) income, or
- 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).
New Guidance for Rental Real Estate Enterprises
The IRS recently issued Notice 2019-7 to clarify when the QBI deduction can be claimed for income from rental real estate enterprises. The notice includes a safe-harbor rule for determining whether a rental real estate enterprise can be treated as an eligible business for QBI deduction purposes.
If a rental real estate enterprise fails to qualify for the safe-harbor rule, it can still be treated as a business for QBI deduction purposes if it meets the general definition of a business set forth in the QBI regulations. Unfortunately, that definition isn’t very clear. (See “Defining a Business under the QBI Regulations” above.)
For purposes of eligibility for the safe-harbor rule, a rental real estate enterprise is defined as an ownership interest in real property held for the production of rents and may consist of an ownership interest in multiple properties.
To rely on the safe-harbor rule, the individual or pass-through entity must own the interest directly or through an entity that’s disregarded for federal income tax purposes. Such entities include single-member LLCs that aren’t treated for tax purposes as separate entities apart from their owners.
Taxpayers must either treat:
Each property held for the production of rents as a separate enterprise, or
All similar properties held for the production of rents as a single rental real estate enterprise.
Commercial and residential real estate can’t be treated as part of the same enterprise. Taxpayers also aren’t allowed to vary their treatment of properties from year to year, unless there’s a significant change in facts and circumstances.
To be eligible for the safe harbor, the taxpayer must pass an hours-of-service test. For tax years beginning before January 1, 2023, at least 250 hours of rental services must be performed each year in the enterprise.
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. But if the enterprise has been held for less than five years, the 250-hour test must be met for each post-2022 tax year.
For tax years beginning after December 31, 2018, eligible taxpayers must maintain separate books and records for each rental real estate enterprise to keep track of each enterprise’s income and expenses. Taxpayers must also maintain contemporaneous records (including time reports, logs, or similar documents) to establish:
- Hours spent on rental services for the enterprise, and
- Descriptions of all rental services performed, including the dates and who performed the services.
For purposes of meeting the hours-of-service test, rental services include:
- Advertising to rent or lease real estate,
- Negotiating and executing leases,
- Verifying information contained in prospective tenant applications,
- Collecting rents,
- Managing daily operations,
- Performing routine maintenance and repair of property,
- Purchasing materials, and
- Supervising employees and independent contractors.
- Rental services can be performed by owners, employees, agents and independent contractors.
Rental services do not include financial or investment management activities, such as:
Studying and reviewing financial statements or reports of operations,
Planning, managing or constructing long-term capital improvements, and
Traveling to and from properties.
Real estate used as a residence by the taxpayer (including an owner or beneficiary of a pass-through entity) for any part of a tax year isn’t eligible for the safe-harbor rule. Real estate rented or leased under a triple net lease also isn’t eligible. With a triple net lease, the tenant or lessee, in addition to paying rent and utilities, agrees to pay taxes, fees and insurance, and to be responsible for property maintenance.
Ready, Set, Go
The Notice 2019-7 guidance on the eligibility of rental real estate enterprises for the QBI deduction isn’t final. But it can be relied upon until final rules are issued by the IRS. Meanwhile, taxpayers should be aware that complying with the recordkeeping requirements in Notice 2019-7 may be a challenge. Your tax advisor can help you set up procedures to meet the challenge.
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