Sec 199A or the Qualified Business Income Deduction allows taxpayers to deduct from taxable income up to 20% of qualified business income (QBI). QBI is income from a domestic business that is reported on your personal tax return such as a sole proprietor, S Corporation, partnership, trust or estate. The deduction is not allowed for C Corporations.
In January 2019 we received final regulations on key parts of this new deduction which are somewhat different than the proposed regulations issued in August 2018.
The new regulations try to answer the big question of what constitutes a trade or business. The tax world has some complex jargon including passive income and material participation (Section 469 passive activity rules) and trade or business (defined in Sec 162.) Rental income is generally considered a passive activity (unless you are a real estate professional), but these rules don’t apply to whether you can take the QBI deduction on your rental activity. So does rental income qualify for the new QBI deduction?
The IRS provided some safe harbor rules to determine if your rental activity is a trade or business. IRS Notice 2019-07 provides the specifics of this new safe harbor rule. Under the safe harbor, a rental activity would be treated as a trade or business if at least 250 hours of services are performed each tax year. This includes services performed by the owners, employees, property management company or other independent contractors to maintain the property, collect rent, pay expenses, provide services to the tenants and advertise and execute leases for the property(ies). Activities such as searching for properties, financing and reviewing financial statements and traveling to and from your property do NOT count for the 250 hours.
If you want your rental activity to qualify as a trade or business you must operate from a separate bank account and maintain good records. You should issue 1099s to all of your independent contractors (those you pay to maintain, repair or manage your property).
You can group your rental activities to qualify for the Safe Harbor hours, but the aggregation rules don’t allow you to combine commercial and residential properties.
In addition to working as a tax professional, I am a real estate investor with several rental activities. I am going back now to substantiate the hours my husband and I worked on our properties in 2018. As an investor, a decent amount of my time is spent compiling financial records (which I think is an important part of being in a trade or business!) The Safe Harbor doesn’t allow me to include this time in my 250 hours. However, the IRS also makes it clear that if you operate your rental activity like a business you improve your chances of qualifying for the QBI deduction.
The IRS Safe Harbor states that “if an enterprise fails to satisfy the requirements of the safe harbor, the rental real estate enterprise may still be treated as a trade or business for purposes of section 199A if the enterprise otherwise meets the definition of trade or business.”
Here is my conclusion on the treatment of rental activities for the QBI deduction. If you cannot met the safe harbor of 250 hours worked on your rental properties AND your rental property doesn’t require a lot of time, you don’t keep separate records, issue 1099s or otherwise act like your activity is a trade or business, then you likely won’t qualify for the QBI 20% deduction. However, if you materially participate in the operation of your rental business and you run it like a trade or business, you may qualify for the QBI deduction because you act like you are running a business.