What is the qualified business income (QBI) deduction?

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.

What is qualified business income?

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: 

  • Trades or businesses conducted through a C corporation
  • Wages earned as an employee
  • Specified service trades or businesses (SSTBs) for taxpayers with taxable income above the threshold. 

For more information on what qualifies as a trade or business, see Determining your qualified trades or businesses in Publication 535.

What property qualifies for the QBI deduction?

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.

Can you deduct qualified business income for a rental property?

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. 

What is a safe harbor deduction for a rental property?

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. 

  • You maintain separate books and records to reflect income and expenses for each rental real estate enterprise.
  • For rental real estate enterprises that have existed for less than four years, 250 or more hours of rental services are performed per year. For other rental real estate enterprises, 250 or more hours of rental services are performed in at least three of the past five consecutive tax years, ending with the current tax year.
  • You attach a statement to your tax return for each year you wish to use the safe harbor. This includes a representation that the safe harbor requirements are satisfied, and a description of all rental properties included in each rental real estate enterprise, including properties acquired and disposed of during the year.
  • You maintain contemporaneous records, including time reports, logs, or similar documents, regarding:
    • Hours of all services performed.
    • Description of all services performed.
    • Dates on which such services were performed.
    • Who performed the services.

 For purposes of the safe harbor, rental services include the following activities: 

  • Advertising to rent or lease the real estate.
  • Negotiating and executing leases.
  • Verifying information contained in prospective tenant applications.
  • Collection of rent.
  • Daily operation, maintenance, and repair of the property.
  • Management of the real estate.
  • Purchase of materials.
  • Supervision of employees and independent contractors. 

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.

Do real estate agents get the QBI deduction?

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. 

The bottom line

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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