A common question that many real estate investors have is whether rental income qualifies as business income. The short answer is that in many cases rental income does qualify as business income, providing an investor with the opportunity to save 20% on taxes.
Key takeaways
- Qualified business income or QBI is the net income generated by a qualified rental real estate enterprise.
- A rental real estate enterprise is a pass-through entity, such as a sole proprietorship or limited liability company.
- In some cases, an investor may be able to claim a QBI tax deduction of up to 20% of the net rental income generated.
- 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 (after all deductions have been made) generated by a qualified trade or business, according to the Internal Revenue Code.
Only taxable income is included in QBI, and certain types of income such as capital gains or losses, interest income, and shareholder wages are not counted as qualified business income.
Is all rental real estate income QBI?
Not all income from rental real estate is qualified business income. Income excluded from QBI includes:
- Property used by a taxpayer during any part of the year, such as a vacation home or second home.
- Rental property on a triple-net lease (NNN) where the tenant pays for maintenance, property taxes, and insurance, in addition to a monthly base rent.
- Rental property located outside of the U.S.
- Rental income generated from land, such as leasing agricultural acreage to a farmer or rancher.
How does the QBI deduction work?
The qualified business income deduction was created by the Tax Cuts and Jobs Act of 2017 (TCJA) and is a new deduction that business owners will be able to take through 2025. As a rule of thumb, the QBI 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 that is not taxed at the corporate level.
Who can claim the QBI deduction?
The QBI deduction claim varies based on a taxpayer’s income level:
- Full 20% QBI deduction for single filers with taxable income less than $157,500 and married couples filing jointly with taxable income less than $315,000.
- Partial QBI deduction for single filers with taxable income between $157,500 – $207,500 and married couples filing jointly with taxable income between $315,00 – $415,000.
- No QBI deduction for single filers with taxable income greater than $207,500 and married couples filing jointly with taxable income greater than $415,000.
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 does. 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)
Do rental properties qualify for the QBI deduction?
Passive rental activities where a landlord or owner has minimal contact with a tenant – such as collecting rent or making repairs – are excluded from the QBI deduction. However, an investor may be able to qualify for the QBI deduction if rental activities are a trade or business and operated as a “rental real estate enterprise.”
In order to be considered as 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.
- Detailed records of service performed must be kept, including 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 are rental services for QBI purposes?
Rental services may be performed by an agent, independent contractor, employee, or an individual real estate investor. Examples of rental services for the purposes of 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
Why the IRS created a “safe harbor” for rental income as QBI
When QBI and the QBI deduction were introduced in 2017 there was a tremendous amount of confusion in the real estate community, and rightly so. That’s because many rental real estate investment activities are considered to be passive, which implies that rental real estate doesn’t constitute a business.
However, passive activity applies to an individual taxpayer, and not the rental real estate enterprise itself. So, for example, even if an individual investor has minimal or no contact with a tenant, the pass-through business may be active with activities such as tenant screening and leasing, repairs and maintenance, and property management.
In 2019, the IRS issued Notice 2019-07 to help clear up confusion about QBI in the real estate industry by providing a “safe harbor” for taxpayers to treat their ownership of rental property as a rental real estate enterprise for the purpose of QBI and the QBI deduction.
Safe harbor requirements for a rental real estate enterprise
According to the IRS, a taxpayer’s rental real estate activities will be treated as a qualified rental real estate enterprise for QBI deduction purposes provided the following safe harbor requirements are met.
Rent collection
A taxpayer must have an interest in a rental real estate enterprise that holds real property for the purpose of collecting rent. For the purposes of QBI, the word “interest” is used to describe 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 or small multifamily property, or in a group of properties. However, residential and commercial property can not be included 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 during the year. For the purposes of the QBI safe harbor, rental services include tasks such as:
- 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
Tasks that are not considered to be 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 actual amount of time spent each week managing a rental property.
Maintain service records
Service records must be detailed and contemporaneous, being originated at the time that a service takes place. 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 a trade or business enterprise may still be eligible for the purposes of 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.
This new release from the IRS also provides more information on how rental real estate may qualify as a business for the QBI deduction.
Closing thoughts
QBI in real estate can be confusing and investors may wish to consult a licensed professional to understand the rules and requirements. However, in many cases, rental income qualifies as business income, provided that the IRS rules are followed. At first glance, 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.
