Have income from rental properties you own? You may be eligible to take a juicy tax break: The 20% qualified business income deduction. Subject to a litany of rules, self-employed individuals and owners of S corporations, partnerships and LLCs can write of 20% of their qualified business income. QBI is your allocable share of income less deductions from a trade or business. It doesn’t include wages, dividends, capital gain or loss, interest income, etc. Eligible filers take the break on their 1040 return.
Applying the QBI rules to rentals is thorny. The rental activity must generally rise to the level of a trade or business. For this purpose, IRS regs refer to the standard under federal tax code Section 162, the statute that generally governs the deductibility of trade or business expenses. There is no statutory or regulatory definition of a Section 162 trade or business. Instead, this determination is based on a taxpayer’s specific facts and circumstances. This analysis is somewhat unclear in the context of a realty rental activity, though the QBI regs point out some factors: Type of property (commercial or residential), extent of day-to-day involvement by the lessor or the lessor’s agent, lease terms, number of properties rented out and other ancillary services provided under the lease.
Owners of rental real estate have a safe harbor to mitigate the uncertainty. If met, you can treat the rental as a trade or business for QBI purposes. At least 250 hours must be devoted to the rental activity by the taxpayer, employees or independent contractors in a year. For realty owned four years or more, the 250-hour requirement must be satisfied in three of the five most recent years. Time spent on repairs and maintenance, tenant services, property management, advertising, collecting rents, negotiating leases and supervising workers counts. Hours put in for arranging financing, constructing long-term capital improvements, and driving to and from the real estate aren’t included in the 250-hour standard. The safe harbor doesn’t apply to property leased under a triple net lease or personally used by the owner for the greater of 14 days or 10% of the days rented.
Users of the safe harbor must meet strict recordkeeping requirements. Contemporaneous records must detail hours, dates and descriptions of the services, and who performed them. If the services are done by contractors or employees, the taxpayer must keep logs of the work done by them, as well as proof of payment. Taxpayers must also attach a statement to their tax return for each year in which they use the safe harbor. See Rev. Proc. 2019-38 for what to include. Special rules apply to taxpayers who own multiple rental properties. They can treat each property separately or they can aggregate similar rental activities into commercial or residential categories. Commercial real estate can be aggregated only with other commercial realty. Ditto for residential rentals. Mixed-use property, such as a building with residential and commercial tenants, may be treated as a separate rental activity or bifurcated into commercial and residential property.
The Kiplinger Tax Letter