QBI Deductions: A Closer Look
As of January 1, 2018, the Tax Cuts and Jobs Act (TCJA) introduced a new business income deduction provision, Section 199A: Qualified Business Income Deductions (QBI). According to the IRS, the new code “provides many taxpayers a deduction for qualified business income from a qualified trade or business operated directly or through a pass-through entity.” The goal of the new deduction is to provide opportunities for “business owners to keep pace with the significant corporate tax cut offered by the Act.”
What is Section 199A?
The new deduction allows for taxpayers to “deduct up to 20% of their QBI, plus 20% of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income.” These deductions are available to owners of partnerships, sole proprietorships, S corporations, and certain trusts and estates.
What is Qualified Business Income (QBI)?
In simple terms, QBI is the net amount of qualified income, gains, deductions, and losses for a qualified trade or business. However, only items included in taxable income are encompassed – items including capital gains and losses, interest income, and certain dividends are not included.
For real estate investors, the QBI deduction “only applies against business income, and not against ‘mere’ investments in real estate.” This has made it challenging to fully understand how real estate investors can benefit from the new rule. Therefore, the IRS released Notice 2019-07.
This Notice has been the guiding factor on the eligibility of rental real estate enterprises for the QBI deduction and has assisted individuals in identifying if they qualify as a “trade or business.” The Notice outlines the safe harbor rule which provides a list of requirements taxpayers must meet to benefit from the deduction. (*Disclaimer: Companies can still qualify if they meet the definition of “trade or business” in Section 1.199A-1(b)(14) – However, these standards are not clear which is why the safe harbor notice was created.
According to the Notice, there are two variables to assess when determining if the rental property qualifies: if the property is a rental real estate enterprise and whether the taxpayer can pass the hours-of-service test.
- Rental Real Estate Enterprises: When reviewing the ownership limitation, taxpayers must meet the following: “the taxpayer’s real estate must be directly owned by an individual or eligible pass-through entities (or through a disregarded entity.)”
The taxpayer must either treat each property separately or treat all properties as one. Commercial and residential properties may not be combined as similar properties. Furthermore, any real estate rented or leased under a triple-net lease is not eligible for the safe harbor; additionally, if the real estate is used as a residence at any point during the year, the property is disqualified from the deduction.
- Hours-of-service test: at least 250 hours of rental services must be performed each year in the enterprise.
These services can be conducted by owners, employees, agents and independent contractors, and can include: collecting rents, managing daily operations, purchasing materials, supervising employees and independent contractors, negotiating and executing leases, verifying information contained in prospective tenant applications, performing routine maintenance and repair of the property, and advertising to rent or lease the real estate. However, rental services do not include investment management activities or financial services.
To qualify, taxpayers must keep track of each enterprise’s income and expenses by maintaining separate books and records for each rental real estate enterprise. This includes records to establish descriptions of all rental services performed (including who performed the service and when) and a log to identify how many hours were spent on rental services for the enterprise. It is important to note that for those claiming after December 31, 2022, a different set of requirements related to the hours-of-service test will be in place.
Benefits of QBI Deductions in Real Estate
Just like any other industry, deductions can help companies save money at the end of the year creating a larger margin of profit. Companies and individuals are recommended to speak with your accountant to confirm that they are utilizing and benefitting from Section 199A.