A common question that many real estate investors have is whether rental income qualifies as business income for purposes of claiming the qualified business income (QBI) tax deduction. The short answer is that in many cases, rental income can qualify as business income, providing some investors with the opportunity to reduce their overall tax burden.
Key takeaways
- Qualified business income or QBI is the net income generated by certain types of self-employed activities and small businesses, including some rental real estate enterprises (RREE).
- The QBI deduction is only available on “pass-through income,” which typically involves one or more of the following entity types: sole proprietorship, partnership, S corporation, or limited liability company (LLC).
- In some cases, an investor may be able to claim a QBI tax deduction of up to 20% of the net rental income generated, subject to total taxable income limits.
- To claim a QBI deduction, an investor must have an interest in a rental real estate enterprise that collects rent, keeps detailed books, and provides at least 250 hours of rental services per year.
What is qualified business income?
Qualified business income or QBI is the net income a qualified trade or business generates after all deductions have been made.
Real estate factors to consider for QBI:
- The type and amount of rented property
- How involved the real estate owner is in the business
- The types of services provided under lease agreements and the lease terms
Qualified business income excludes certain types of income, such as some investment items like capital gains or losses and interest.
What is rental income?
Rental income is any payment you receive for the use or occupation of the rental property. Per the IRS, “you generally must include in your gross income all amounts you receive as rent.” Remember, you can deduct the expenses of renting property from your gross rental income.
Examples of rental income
- Any rent received from a tenant, including pet rent or late fees
- Expenses paid by a tenant that are typically the responsibility of the landlord, such as painting the home or doing yard work in exchange for a credit against rent
What is the QBI deduction?
The Tax Cuts and Jobs Act of 2017 (TCJA) created the qualified business income deduction.
At first, there was tremendous confusion in the real estate community because many investment activities are considered passive, so the deduction seemed to imply that rental real estate didn’t constitute a qualified “business” under the new law.
However, the passive nature of the activity applies to an individual taxpayer, not the rental real estate enterprise itself. So, for example, if an individual investor has minimal or no contact with a tenant, the pass-through business may still be active through activities such as tenant screening and leasing, repairs and maintenance, and property management.
IRS introduces “Safe Harbor”
In 2019, the IRS issued Notice 2019-07 to clear up confusion about QBI in the real estate industry by providing a “safe harbor” for taxpayers. As long as the safe harbor requirements are met, taxpayers can treat their rental property ownership as a rental real estate enterprise for purposes of claiming the QBI deduction.
How to qualify rentals for the QBI deduction
Here are a few requirements, per the safe harbor rules, to qualify rental activities for the qualified business income deduction.
Rent collection
A taxpayer must have an ownership interest in a rental real estate enterprise that holds real property to collect rent. For QBI, “interest” describes a taxpayer’s claim to real property, such as the percentage of ownership.
The interest can be in one property, such as a single-family rental home, small multifamily property, or a group of properties. However, residential and commercial property can not be commingled in the same enterprise or group.
Separate books
Each rental real estate enterprise must maintain separate books and records to track income and expenses. Free rental property financial management software from Stessa can help real estate investors automatically keep track of income and expenses at both the property and portfolio level.
Minimum rental services
A rental real estate enterprise must perform at least 250 hours of rental services annually. For the QBI safe harbor, rental services include tasks such as:
- Marketing the property for lease
- Screening tenants and signing a lease
- Collecting rent from tenants
- Responding to maintenance requests
- Coordinating repairs with vendors
- Purchasing materials and supplies
- Supervising contractors and employees
- Property management activities
Tasks not considered rental services include traveling to and from a rental property, restoring the property, and reviewing financial statements and operating reports.
While 250 hours per year may seem like a lot of time, it’s less than 5 hours per week. That amount of time is also per rental real estate enterprise, not per property. An investor may wish to consult with a good local property manager to get an idea of the time spent each week managing a rental property.
Maintain service records to support time spent
The taxpayer must maintain contemporaneous records. Records may be in the form of a log or report, or a similar document that includes the following information:
- Date service was performed
- Person or organization performing the service
- Amount of time spent performing the service
- Description of the service performed
It’s important to note that, in some situations, a trade or business enterprise may still be eligible for the QBI deduction if the above rental services requirements are not met. An investor may wish to consult with their tax professional to see if the enterprise will still meet the IRS definition of a trade or business.
How to calculate QBI deduction
As a rule of thumb, the QBI deduction, also known as the section 199a deduction, is equal to the lesser amount of:
- 20% of qualified business income
- 20% of taxable income less net capital gain
Qualified business income must come from a “pass-through” real estate business entity not taxed at the corporate level. Importantly, this deduction is also subject to income limits, per the discussion below.
FAQs on rental income for QBI
Here are the most frequently asked questions on QBI and rental income.
Who can claim the QBI deduction?
If your total taxable income is at or below $182,100 for single filers or $364,200 for joint filers in 2023, you may qualify for the 20% deduction on your taxable business income. Within these ranges, the deduction is limited. Above these ranges, there is no deduction.
What is a pass-through real estate business?
A pass-through business in real estate is an entity that passes income and expenses from a rental property through to the individual taxpayer. While pass-through entities may file a tax return, they do not pay taxes at the corporate level like a C corporation. Instead, any taxable income or loss is reported on an individual’s tax return.
Examples of pass-through business entities used in real estate include:
- S Corporation
- Limited liability company (LLC)
- Limited partnership (LP)
- Sole proprietorship
- Estate
- Trust
- Publicly traded partnership (PTP)
- Real estate investment trust (REIT)
What’s considered a “rental real estate enterprise?”
An investor may qualify for the QBI deduction if rental activities are associated with a trade or business operated as a “rental real estate enterprise.”
To be considered a rental real estate enterprise, the primary purpose of the business must be to generate a profit, and a taxpayer’s involvement must be continuous. Each rental property or group of similar properties (such as a group of single-family rentals) must also:
- Maintain books to track income and expenses
- Keep detailed records of services performed, including the date of the service, description of the service, who performed the service, and how long the work took
- Each trade or business enterprise must perform at least 250 hours of rental services per year
What is considered “rental services?”
Rental services may be performed by an agent, independent contractor, employee, or an individual real estate investor. Examples of rental services for QBI include:
- Marketing the property for lease
- Screening tenants and signing a lease
- Property management activities
- Collecting rent from tenants
- Responding to maintenance requests
- Coordinating repairs with vendors
- Purchasing materials and supplies
- Supervising contractors and employees
Services and activities that are generally not considered to be rental services include:
- Researching rental property to purchase
- Negotiating a purchase and sale agreement
- Arranging financing
- Analyzing financial statements and reports
- Devising capital improvement or property upgrading projects
- Traveling to and from a rental property
Does the safe harbor apply to triple net leases?
Per the IRS guidelines, the safe harbor does not apply to real estate enterprises with triple net leases. For this specific exclusion, the “triple net lease” “includes a lease agreement that requires the tenant or lessee to pay taxes, fees, and insurance, and to pay for maintenance activities for a property in addition to rent and utilities.”
Does your rental qualify?
QBI in real estate can be confusing, and investors should consult a licensed professional to understand the rules and requirements. In many cases, rental income qualifies as business income, provided that the IRS rules are followed.
At first, keeping accurate track of income, expenses, and the required record-keeping may seem like a lot of work. But, the possibility of saving 20% on taxable income with the QBI deduction can be a powerful incentive.
