The Tax Cuts and Jobs Act of 2017 – with its many changes impacting the 2018 tax year and beyond – brought the Qualified Business Income deduction (sometimes called the QBI deduction or 199A deduction). This new deduction can be up to 20% of the net income of a qualified business, meaning only 80% of your QBI is taxed on the federal level. But, if you are a real estate investor you are probably wondering if this deduction will apply to you. The answer is, of course, not so simple.
Defining a Qualified Trade or Business
The biggest limitation of the QBI deduction is that it only applies to a “qualified trade or business”. There is not a lot of clarity within IRS regulations in determining what exactly is a trade or business in the real estate arena and there are many unique situations concerning real estate.
The IRS cites “key factual elements” that are relevant to whether an activity is a trade or business: (a) the type of property (commercial versus residential versus personal); (b) number of properties rented; (c) day to day involvement of the owner or agent; and (d) type of lease (triple-net versus traditional). Therefore, due to the large number of actual combinations that exist in determining whether a rental activity rises to the level of a trade or business, the IRS says bright-line definitions are impractical.
Below are a few example situations that demonstrate when real estate investments would likely or likely not pass as a qualified trade or business.
- If an investor owned a single property and it was leased under a triple-net lease with an unrelated party, it would likely NOT qualify as a trade or business. In a triple-net lease, the tenant pays the owner rent and the tenant is also responsible for the real estate taxes, repairs and maintenance of the property. The investor activity is generally limited to the collection of rent. Upon audit it would be difficult to prove these rental activities constitute a trade or business.
- If in the above situation the triple-net lease was associated with a qualified trade or business with at least 50% common ownership, the rental property would not be excluded from the QBI deduction as this would be a trade or business under the new rules. If the income comes from multiple tenants, one being a related party and one being unrelated, only the portion attributable to the related party will be considered to be an active trade or business.
- If a real estate investor was a retired individual who owned and rented five residential properties and regularly maintained the properties, collected rents, paid bills and found tenants, there likely would be a strong argument that this would constitute a trade or business. This individual should keep a log of their daily activities relating to the rental properties should they need to later prove their participation under audit.
We can help you determine if your rental activity facts and circumstances can give rise to a trade or business and thus allow you to be eligible for QBI. If you are not eligible, we can develop some operational strategies which can allow you to qualify for the deduction. Please contact us today at 630-953-4900.