Let’s talk about what QBI is and how it could apply to your rentals for a second…
What is the Qualified Business Income (QBI) deduction and does it apply to rental income? One of the changes included in The Tax Cuts and Jobs Act of 2017 that is creating a lot of buzz is the deduction for small business owners of up to 20% of their income from qualified businesses – sole proprietorships and passthrough entities such as LLCs, partnerships and S corporations. The so-called Qualified Business Income or “QBI” deduction is in place for tax years 2018-2025 and promises to save small business owners millions of tax dollars.
The IRS received a lot of feedback on QBI deduction with many clamoring to know whether income from rental activities qualifies for the deduction. Rental properties are generally considered passive activities and therefore excluded from the definition of a qualified trade or business. There are, however, some important exceptions that could apply to your particular situation. Don’t miss out on the opportunity to claim the full QBI deduction to which you are entitled!
- Under general IRS rules, a real estate professional is considered to be engaged in a business and will therefore have qualified business income. To be a real estate professional, you need to spend more than 750 hours on your real estate business, and this needs to be greater than 50% of the personal services you perform for the year.
- The IRS has also established safe harbor requirements that allow a rental enterprise to be considered a trade or business for purposes of the QBI deduction. A rental enterprise meets the safe harbor if 250 or more of hours of rental services are performed during the year, separate books are maintained, and contemporaneous records are kept to document hours of service. The rental services can be performed by the owner, employees, agents, or contactors.
- There is also an exception that allows rentals to be treated as qualified businesses and thus eligible for the QBI deduction when the property is rented to a qualified business which is owned by the same individual. This activity can be referred to as a “self-rental”.
The focus of this article will be the exception which allows income from “self-rentals” to be considered qualified business income. It is not uncommon for individuals to purchase real estate or other assets which they then rent to their business. Assuming the business to which the property is rented is a qualified sole proprietorship or passthrough entity under common control, the rental will be treated as a qualified business as well. Common control in this case means that the same owner or group of owners owns at least 50% of the property being rented and at least 50% of the business to which it is rented.
How does “self-rental” fit into the bigger picture of the QBI deduction?
(Note all dollar amounts listed reflect 2018 limits which will be indexed for inflation.)
In general – The 20% of QBI deduction is calculated on the taxable income from each of the taxpayer’s qualified sole proprietorship(s) or pass-through business(es). If the taxpayer has a self-rental or other rental income that qualifies for the deduction, a QBI deduction is calculated for each of these activities as well. Once a combined QBI amount is calculated it is then subject to an overall limitation of 20% of taxable income after subtracting net capital gains.
Two issues arise for taxpayers with taxable income above $205,500 ($415k married-filing-joint).
- If the trade or business is deemed to be a Specified Service Trade or Business(SSTB), it no longer qualifies for a QBI deduction.
- A SSTB is a trade or business with the main asset being the reputation or skill of one or more of its employees or owners. Examples include trades or businesses in the fields of health, law, engineering, accounting and financial services.
- Self-rental income is treated in the same manner as the associated business. This means that net income from a self-rental to an SSTB would also be treated as SSTB net income.
- If the trade or business is NOT a SSTB, the regularly calculated QBI deduction is limited to the greater of the amounts calculated under the following two tests:
- Wage Test – 50% of the taxpayer’s share of W-2 wages paid by the qualified business
- Wage and Depreciable Property Test (applicable to real estate and other capital intensive businesses) – 25% of the taxpayer’s share of W-2 wages plus 2.5% of the taxpayer’s share of the original unadjusted basis of depreciable property.
Taxpayers with taxable income between $157,500-$205,500 ($315k-$415k) are subject to a phase in of the Wage and Property tests and, in the case of an SSTB, a phase out of the QBI deduction. Your tax accountant and commercially available tax software will be able to make the complex calculations so you don’t miss out on the deduction to which you are entitled. With the QBI deduction scheduled to expire after the 2025 tax year, you will want to take full advantage while you can!
If you have questions about how to maximized your QBI deduction, or about self-rental, don’t hesitate to contact us. We’re happy to help (and don’t bite)!