We added this as an addendum in my book, The Real Estate Investor Tax Guide to include changes made by the new Tax Cuts and Jobs Act (TCJA) passed in December 2017, which affects returns for 2018 through 2025. Most of the changes in the law are scheduled to revert back to the prior law after the 2025 tax year unless Congress extends it.
Herein, we will refer to the new Tax Cuts and Jobs Act either as “The New Tax Law” or TCJA.
Qualified Business Income rules (QBI)
The TCJA created a new deduction for “Qualified Businesses” known as the QBI deduction.
First, what is the QBI Deduction?
The QBI deduction is a deduction for certain qualified trades or businesses, such as real estate investors, where your net rental income (if it qualifies) will create an additional deduction of up to 20% of your net rental income. This is the simple answer, but there are many complex rules that come into play if your income exceeds certain guidelines, and in certain situations, your rental income may NOT qualify.
Rental income that does NOT qualify for the QBI deduction are:
- Real estate used by the owner
- Real estate rented under a triple net lease
- Self-rental real estate rented to an owner of an SSTB* if the ownership is 50% or more owned by the SSTB*
The good news is that rental properties, for the most part, qualify for this new deduction.
Note that the deduction is only available to individual taxpayers and not to regular corporations.
Although pass-through entities’ net income qualifies for the QBI, it does so at the individual taxpayer level and not directly to the pass-through entity such as Partnerships, S-Corporations, and LLCs.
Following are the phase-out amounts for 2019:
- Married Filing Jointly: $321,400 to $421,400
- Married Filing Separately: $160,725 to $210,725
- All other taxpayers: $160,700 to $210,700
These limits are indexed for inflation each year.
When your income reaches the phase-out amounts, part of the 20% QBI deduction begins to “phase out” or disappear until it is completely gone, and a different set of rules comes into play.
Above the phase-out amount, the following is available for the QBI deduction:
- 50% of W-2 wages paid by the business …or…
- 25% of W-2 wages paid by the business plus 2.5% of the unadjusted basis of assets
IRS notice 2019-7 outlined the rules specific to rental real estate that qualify for the QBI deduction:
- You must keep separate books and records showing the income and expenses for each property.
- You must perform at least 250 hours of real estate rental services each year for each property.
- You must document the real estate services performed.
- You must issue 1099’s to all vendor providing services
Hours of Service test
To be eligible, the taxpayer must pass an Hours of Service Test.
This test requires the taxpayer to document at least 250 hours of services performed per property.
You must document these hours of service, the description of the service, the dates these services were performed, and who performed the services.
Services that qualify include:
- Advertising to rent
- Negotiating leases
- Collecting rents
- Performing maintenance and repairs (but not the construction of capital improvements)
- Supervising contractors and employees
Services do not include traveling to and from the properties.
The services do not have to be performed by the owner themselves but can be performed by agents, employees, or independent contractors.
250 Hour test: if you own multiple properties trying to document 250 hours for each property can be daunting. You can combine properties as a single enterprise to deal with this challenge. But you still have to keep separate residential rental from commercial rental. You must elect in the return to combine these rentals into a single enterprise.
*SSTB defined: a Specified Service Trade or Business (SSTB) is a certain class of business excluded from taking the QBI deduction because of the trade or business they are involved in.