The Qualified Business Income (QBI) deduction, introduced by the Tax Cuts and Jobs Act of 2017, offers taxpayers a potential reduction in taxable income. For property owners earning rental income, determining whether this income qualifies for the QBI deduction can be challenging, as not all rental activities meet the criteria for a trade or business under tax regulations.
Understanding the factors that separate qualifying rental activities from non-qualifying ones is essential for maximizing tax benefits. Key considerations include trade or business status, material participation, and specific safe harbor provisions.
Determining Trade or Business Status
To qualify rental income for the QBI deduction, the rental activity must constitute a trade or business. The Internal Revenue Code does not explicitly define this term, but guidance from Section 162 suggests the activity must be conducted with regularity and for the primary purpose of generating income or profit. Occasional or infrequent rentals may not meet this standard. For QBI purposes, the IRS explains that qualified trades or businesses generally follow the section 162 “regular, continuous, and profit-motivated” test. 1Internal Revenue Service. Instructions for Form 8995
The distinction between a trade or business and an investment depends on the level of involvement and the nature of the operations. For instance, a landlord managing multiple properties with consistent leasing activities is more likely to qualify than someone renting out a single property sporadically. The IRS evaluates factors such as the number of properties, the extent of services provided, and the taxpayer’s role in management. Active involvement in tasks like tenant relations, maintenance, and leasing agreements strengthens the case for trade or business classification.
Case law, such as Groetzinger v. Commissioner, also provides insight into what constitutes a trade or business. The Supreme Court emphasized the importance of regular and continuous activity. Maintaining detailed records of rental operations, including time spent and services provided, can help substantiate trade or business status during an IRS audit.
Assessing Material Participation
Material participation affects whether rental income is passive under the section 469 rules, but it is not a requirement for claiming the QBI deduction. The IRS states that material participation under section 469 isn’t required to qualify for the QBI deduction. 2Internal Revenue Service. Instructions for Form 8995-A
The IRS outlines seven tests for material participation, with the most common being the “500-hour test,” which requires taxpayers to spend more than 500 hours on the activity annually. Activities such as coordinating repairs, managing leases, and handling tenant issues can help meet this threshold. Another relevant test is the “substantially all” test, where the taxpayer performs nearly all work related to the activity. When managing multiple properties, taxpayers can aggregate their participation if the properties are part of a single economic unit.
Real Estate Safe Harbor Criteria
The IRS safe harbor provision, outlined in Revenue Procedure 2019-38, provides a clear framework for landlords seeking to qualify their rental income for the QBI deduction. To use the safe harbor, taxpayers must maintain separate books and records for each rental real estate enterprise, perform at least 250 hours of rental services (by the owner, employees, or contractors) in the required years, keep contemporaneous records of those services, and attach an annual statement to the tax return; certain arrangements, including triple net leases and properties used as a residence under section 280A, are excluded from the safe harbor. If the safe harbor isn’t met, the rental may still qualify if it otherwise rises to a section 162 trade or business. 3Internal Revenue Service. Rev. Proc. 2019-38 (Rental Real Estate Safe Harbor)
This is particularly helpful for those managing multiple properties.
Documentation for Qualification
Accurate documentation is essential for landlords aiming to qualify for the QBI deduction. Detailed records demonstrate compliance with tax criteria and protect against potential audits. Landlords should maintain comprehensive ledgers of income, expenses, and contracts related to their rental activities.
A detailed log of hours spent on rental tasks is equally important. Entries should include dates, task descriptions, and time spent. Property management software can simplify this process, ensuring accuracy and consistency in record-keeping.
Distinguishing Passive vs Nonpassive Rentals
The distinction between passive and nonpassive rental activities is vital when assessing overall tax treatment, but it does not determine QBI eligibility by itself. What matters for QBI is whether the rental rises to a section 162 trade or business. Passive rental income typically stems from minimal taxpayer involvement, whereas nonpassive income requires active engagement in managing the properties.
For example, landlords who outsource all management tasks to a property management company may find their rental income categorized as passive. This is common for investors with properties in distant locations. Conversely, taxpayers directly involved in tasks like tenant screening and overseeing repairs are more likely to qualify as nonpassive, meeting the material participation requirements for other parts of the tax law. Maintaining detailed records of involvement is key to substantiating claims.
Nonqualifying Rental Scenarios
Certain scenarios can prevent rental income from qualifying under the safe harbor even if the activity otherwise appears active. Triple net lease arrangements, where tenants cover property expenses like taxes and maintenance, and properties used as personal residences under section 280A, are excluded from the safe harbor; however, a rental that fails the safe harbor may still qualify for QBI if it is a section 162 trade or business.
Rental properties held in investment vehicles such as Real Estate Investment Trusts (REITs) are different: dividends from a REIT are not rental income, but “qualified REIT dividends” are separately eligible for the section 199A deduction of up to 20%, distinct from QBI from a trade or business. 4Internal Revenue Service. Qualified Business Income Deduction
Taxpayers should carefully evaluate their rental arrangements and consult a tax professional to navigate the complexities of QBI eligibility and optimize potential benefits.