As any small business owner knows well, understanding the tax implications of a business is critical to making informed decisions about how to manage your taxes from year to year.
For real estate professionals, there are many potential tax advantages. Yet, understanding how best to maximize your tax strategy for your real estate business can be daunting, especially in light of the sweeping changes to the tax code that the IRS has enacted over the past few years.
One such change, the introduction of the qualified business income deduction, left real estate professionals confused. Understanding this deduction, however, can yield significant benefits for eligible businesses.
To learn more about the qualified business income (QBI) deduction, and discover what it means for your real estate business or rental property, continue reading below.
In the past, the combined total tax rate on corporations was approximately 50%. Meanwhile, “pass-through” entities—companies such as partnerships, S corporations, and most LLCs, are structured to pass all income on to the owners or investors of the company. This meant they were taxed at the personal rate—at a top rate of 39.6%.
That meant that operating as a pass-through entity previously offered a 10% advantage over corporations at tax time.
This all changed in 2017 with alterations to both tax rates in the Tax Cuts and Jobs Act (TCJA). The TCJA reduced the corporate tax rate to 21% and the top individual rate to 37%, which would have reduced the approximate 10% pass-through advantage to less than 3%. To address this and preserve the pass-through advantage, the act also introduced a 20% qualified business income (QBI) deduction for pass-through businesses, effectively subjecting only about 80% of eligible pass-through income to tax.
Section 199A provision allows eligible non-corporate taxpayers to deduct up to 20% of qualified business income from a partnership, S corporation, LLC, or sole proprietorship for tax years beginning after December 31st, 2017.
According to the IRS, qualified business income, or QBI, is “the net amount of qualified items of income, gain, deduction, and loss from any qualified trade or business.”
To explain it more simply: Qualified business income refers broadly to your business’s net profit.
However, all business income does not necessarily qualify. For example, the IRS does not count any items not included in taxable income, nor items such as capital gains and losses, certain dividends, and interest income.
W-2 income, amounts received as reasonable compensation from an S corporation, amounts received as guaranteed payments from a partnership, and payments received by a partner for services under section 707(a) are also not QBI.
To count as qualified business income, the items must be effectively connected with a U.S. trade or business. That includes any trades or businesses for which you are allowed a deduction for ordinary and necessary business expenses but does not include the following:
For more information on what qualifies as a trade or business, see Determining your qualified trades or businesses in Publication 535.
The new QBI deduction has been a source of confusion for those in the real estate world who wondered whether or not their rental properties would qualify as a trade or business for purposes of the QBI deduction.
This uncertainty led to the IRS releasing guidance on the subject in the form of Revenue Procedure 2019-38, which has a “safe harbor” allowing taxpayers to treat particular interests in rental real estate, including mixed-use property, as a trade or business to qualify.
In general, the IRS usually treats income from rental real property held for investment purposes and reported on Schedule E (Form 1040) as passive activities and, therefore, not eligible for the QBI deduction.
However, you may be eligible for the deduction if you operate the activity as a real estate trade or business under U.S. Code § 162.
The aforementioned safe harbor may allow you to treat your rental real estate enterprise as a trade or business solely for purposes of the QBI deduction.
On the other hand, if your rental real estate enterprise does not satisfy the safe harbor requirements (which we’ll discuss below), it may still qualify as a trade or business for the QBI. As long as it meets the definition under Section 162, other than the trade or business of performing services as an employee.
The IRS defines a trade or business as any activity carried on to produce income from selling goods or performing services. For example, you may be in a trade or business if you provide substantial services in conjunction with the property primarily for your tenant’s convenience (regular cleaning, changing linen, etc.) or if you are a real estate professional.
If you’re unfamiliar with the term “safe harbor” as it applies to taxes, it is a type of IRS rule that protects certain taxpayers from a penalty under certain conditions. You can use the safe harbor rule for certain estimated taxes, which can provide flexibility to how much you need to pay. The IRS may waive or reduce penalties such as underpayment when necessary conditions exist.
In the case of rental property, you can treat your rental real estate enterprise as a trade or business under safe harbor (solely for the QBI deduction) if the business has satisfied all of the following requirements during the tax year.
For purposes of the safe harbor, rental services include the following activities:
Owners, employees, or independent contractors of the owners may perform rental services. The term “rental services” does not include financial or investment management activities or hours spent traveling to and from the real estate.
As real estate agents are independent contractors, many agents choose to organize their activities as a sole proprietorship. The TCJA initially classified real estate agents as specified service trades or businesses (SSTBs), excluding them from the QBI deduction when their business income exceeds thresholds.
However, in 2019, after advocacy from professional organizations, including the National Association of Realtors, the Treasury Department and IRS created a special carveout for real estate agents. This ruling removed them from the SSTB classification, allowing them to claim the full 20% QBI deduction regardless of whether their income exceeds the threshold.
Whether you own rental property or are a real estate agent, taking full advantage of the 20% qualified business income deduction can become complicated, especially when your income is at a higher level.
However, the QBI provision offers vital benefits for an eligible pass-through trade or business. You’ll want to maximize your tax strategy by taking full advantage of this deduction whenever possible.
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Above & Beyond
New York City
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Jeff Coyle, CPA, Partner of Rosenberg Chesnov, has been with the firm since 2015. He joined the firm after 20 years of business and accounting experience where he learned the value of accurate reporting, using financial information as a basis for good business decisions and the importance of accounting for management.
He is a diligent financial professional, able to manage the details and turn them into relevant business leading information. He has a strong financial background in construction, technology, consulting services and risk management. He also knows what it takes to create organizations having built teams, grown companies and designed processes for financial analysis and reporting.
His business experience includes:
Creating and preparing financial reporting, budgeting and forecasting.
Planning and preparation of GAAP and other basis financial statements.
Providing insight on financial results and providing advice based on those results.
Jeff also has a long history of helping individuals manage their taxes and plan their finances including:
Income tax planning and strategy.
Filing quarterly and annual taxes.
General financial and planning advice.
Prior to joining the firm in 2015, Jeff was in the private sector where he held senior financial and management positions including Controller and Chief Financial Officer. He has experience across industries, including construction, technology and professional services which gives him a deep understanding of business.
Jeff graduated from Montclair State University, he is a CPA and member of the American Institute of Certified Public Accountants, New York State Society of Certified Public Accountants and New Jersey State Society of Public Accountants.
Jody H. Chesnov, CPA, Managing Partner of Rosenberg Chesnov, has been with the firm since 2004. After a career of public accounting and general management, Jody knows the value of good financials. Clarity, decision making, and strategy all start with the facts – Jody has been revealing the facts and turning them into good business results for more than three decades.
He takes a pragmatic approach to accounting, finance and business. His work has supported many companies on their path to growth, including helping them find investors, manage scaling and overcome hurdles. His experience and passion for business reach beyond accounting and he helps businesses focus on what the numbers mean organizationally, operationally and financially.
He has a particular expertise in early-stage growth companies. His strengths lie in cutting through the noise to come up with useful, out of the box, solutions that support clients in building their businesses and realizing their larger visions.
Prior to joining the firm in 2004, Jody was in the private sector where he held senior financial and management positions including General Manager, Chief Financial Officer and Controller. He has experience across industries, which gives him a deep understanding of business.
Jody graduated with a BBA in Accounting from Baruch College, he is a CPA and member of the American Institute of Certified Public Accountants and New York State Society of Certified Public Accountants.
In addition to delivering above and beyond accounting results, Jody is a member of the NYSCPA’s Emerging Tech Entrepreneurial Committee (ETEC), Private Equity and Venture Capital Committee and Family Office Committee.
He is an angel investor through the Westchester Angels, and has served as an advisor for many startup companies and as a mentor through the Founders Institute.
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