The new qualified business income (QBI) deduction, also known as the section 199A deduction, that may be available to individuals, including many owners of sole proprietorships, partnerships and S corporations. Some trusts and estates may also be able to take the deduction. This deduction, created by the 2017 Tax Cuts and Jobs Act, allows non-corporate taxpayers to deduct up to 20 percent of their QBI, plus 20% of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income.
One of the most confusing parts of the tax law is whether this law applies to real estate transactions. Below are some questions/answers to how the IRS determines whether those involved in the real estate business can meet that requirement:
When is rental real estate treated as a trade or business for purposes of determining the QBI deduction?
Rental real estate is treated as a trade or business for purposes of the QBI deduction under section 199A if it meets any of the following three tests:
- The rental real estate rises to the level of a section 162 trade or business. (an activity that the courts and the Internal Revenue Service in past decisions count as a real trade or business that generates legitimate Section 162 business deductions)
- The rental real estate is a rental real estate enterprise meeting the requirements of the safe harbor provided in Revenue Procedure 2019-38. (see next question)
- The rental or licensing of property is to a commonly controlled trade or business operated by an individual or a pass-through entity. Also know as Self-rental, this is an arrangement in which a business and property that it rents are both owned by the same person(s). It is common for a taxpayer to own an operating business and also own the accompanying real estate. That person has to materially participate in the operating company for the self rental rules to apply.
When is a rental real estate enterprise eligible to rely upon the safe harbor provision?
Revenue Procedure 2019-38 provides a safe harbor under which a rental real estate enterprise that meets certain requirements will be treated as a trade or business for purposes of section 199A. In order to rely upon the safe harbor, the enterprise must meet all requirements of the Revenue Procedure.
A rental real estate enterprise is defined as an interest in real property held for the production of rents and may consist of an interest in a single property or interests in multiple properties. The interest must be held directly or through a disregarded entity (Schedule C) by the individual or relevant pass-through entity (RPE) relying on the safe harbor. Multiple properties of the same category (residential or commercial) can be treated as a single enterprise if the individual or RPE also includes all other properties of the same category in the enterprise. Residential and commercial property cannot be combined into a single property except for mixed-use property as discussed later. To qualify under the safe harbor, the rental real estate enterprise must satisfy all of the following requirements:
- Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise. If a rental real estate enterprise contains more than one property, this requirement may be satisfied if income and expense information statements for each property are maintained and then consolidated;
- For rental real estate enterprises that have been in existence less than four years, 250 or more hours of rental services are performed (as described in Revenue Procedure 2019-38) per year with respect to the rental real estate enterprise. For rental real estate enterprises that have been in existence for at least four years, in any three of the five consecutive taxable years that end with the taxable year, 250 or more hours of rental services are performed (as described in Revenue Procedure 2019-38) per year with respect to the rental real estate enterprise; and
- The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, regarding the following: (i) hours of all services performed; (ii) description of all services performed; (iii) dates on which such services were performed; and (iv) who performed the services. If services with respect to the rental real estate enterprise are performed by employees or independent contractors, the taxpayer may provide a description of the rental services performed by such employee or independent contractor, the amount of time such employee or independent contractor generally spends performing such services for the enterprise, and time, wage, or payment records for such employee or independent contractor. Such records are to be made available for inspection at the request of the IRS.
- The taxpayer or RPE attaches a statement to a timely filed original return, including extensions, (or an amended return for the 2018 taxable year only) for each taxable year in which the taxpayer or RPE relies on the safe harbor. An individual or RPE with more than one rental real estate enterprise relying on this safe harbor may submit a single statement but the statement must list the required information separately for each rental real estate enterprise. The statement must include the following information:
- A description (including the address and rental category) of all rental real estate properties that are included in each rental real estate enterprise;
- A description (including the address and rental category) of rental real estate properties acquired and disposed of during the taxable year; and
- A representation that the requirements of this revenue procedure have been satisfied.
Certain rental real estate arrangements are excluded from the safe harbor and may not be included in a rental real estate enterprise. These include real estate used by the taxpayer as a residence under section 280A; real estate rented under a triple net lease; real estate rented to a trade or business conducted by a taxpayer on an RPE which is commonly controlled under section 1.199A-4(b)(1)(i) and rental real estate where any portion of the property is treated as a specified service trade or business (SSTB).
How can I meet the records requirement of the safe harbor and what happens if I don't meet it?
Reliance upon the safe harbor requires the maintenance of contemporaneous records, including time reports, logs or similar documents, regarding the hours of all services performed, a description of services performed, dates on which such services were performed and who performed the services.
If an employee or independent contractor performed the services with respect to the rental real estate enterprise, the taxpayer may provide a description of the rental services performed, the amount of time the employee or independent contractor generally spent performing the services for the enterprise, and time, wage or payment records for the employee or independent contractor.
The safe harbor is not available to taxpayers that fail to meet the contemporaneous records requirement. However, the rental real estate may still be treated as a trade or business for purposes of the QBI deduction if the rental real estate otherwise rises to the level of a section 162 trade or business or meets the self-rental rule. Whether rental real estate rises to the level of a trade or business under section 162 depends on all facts and circumstances.
How does the safe harbor apply to mixed-use properties?
Mixed-use property is a single building that combines residential and commercial units. An interest in mixed-use property may be treated as a single rental real estate enterprise or may be split into separate residential and commercial properties. If treated as a single rental real estate enterprise, it may not be treated as part of the same enterprise as other residential, commercial or mixed-use property.
For example, a taxpayer has three mixed-use buildings and each includes a storefront and an apartment. For purposes of the safe harbor, the buildings can be included in a rental real estate enterprise in any of the following ways:
- Each mixed-use building is treated as two separate interests in rental real estate, one commercial and one residential. The taxpayer treats these as six separate rental real estate enterprises, three commercial and three residential.
- Each mixed-use building is treated as two separate interests in rental real estate, one commercial and one residential. The taxpayer treats the three commercial interests as a single rental real estate enterprise and also treats the three residential interests as a separate single rental real estate enterprise. The taxpayer has two rental real estate enterprises, one commercial and one residential.
- Each mixed-use building is treated as two separate interests in rental real estate, one commercial and one residential. The taxpayer treats the three commercial interests as a single rental real estate enterprise but treats the residential interests as three separate single rental real estate enterprises. The taxpayer has four rental real estate enterprises, one commercial and three residential.
- Each mixed-use building is treated as two separate interests in rental real estate, one commercial and one residential. The taxpayer treats the three residential interests as a single rental real estate enterprise but treats the commercial interests as three separate single rental real estate enterprises. The taxpayer has four rental real estate enterprises, three commercial and one residential.
- Each mixed-use property is treated as a stand-alone enterprise containing both residential and commercial properties. The taxpayer has three rental real estate enterprises, three mixed-use.
If other non-mixed-use properties are also owned or subsequently acquired, the similar properties rule still applies. In other words, if the mixed-use properties are split into residential and commercial properties, the requirement to either treat all similar properties as their own enterprises or as a single enterprise will include these properties, as well.
For example, if the taxpayer described in example b above acquires an additional commercial property, that new property must also be added to the existing commercial real estate enterprise. The taxpayer may not treat the newly acquired commercial property as its own enterprise.
Once an enterprise determination is made, the rules of the safe harbor are applied to each enterprise.
If rental real estate is treated as a trade or business for purposes of the QBI deduction, do I report the rental real estate on Schedule C of my Form 1040, and is it subject to self-employment tax?
In general, the answer to both questions is no. How rental real estate is reported on Form 1040 has NOT changed due to the QBI deduction. Rental real estate is usually reported on Schedule E, Part I, and is not subject to self-employment tax.
Even if rental real estate rises to the level of a section 162 trade or business, it is generally reported on Schedule E, Part I, because rental real estate is generally excluded from self-employment taxable income under section 1402(a)(1).
However, some rental real estate is subject to self-employment tax (e.g., boarding house, hotel or motel, and bed and breakfast, where substantial services are rendered for the convenience of the occupants). Rental real estate subject to self-employment tax is reported on Schedule C.
Can rental real estate that is a trade or business for purposes of section 199A be added together with other businesses?
Rental real estate that is a trade or business can be aggregated with other trades or businesses, including other rental real estate trades or businesses, if the rules of section 1.199A-4 of the Regulations are met. This includes rental real estate that rises to the level of a section 162 trade or business, rental real estate enterprises that meet the safe harbor requirements of Revenue Procedure 2019-38 and self-rentals as described in section 1.199A-1(b)(14).
Do I have to materially participate in rental real estate for it to qualify for the QBI deduction?
No. Section 199A does not have a material participation requirement. Eligible taxpayers with income from a qualified trade or business may be entitled to the QBI deduction regardless of their level of involvement in the trade or business.
If my rental real estate generates a net loss that is limited by the passive activity loss limitations, what do I do with those losses for QBI purposes?
Any losses from a trade or business that are suspended and not available for use in computing taxable income in the year incurred are not included in QBI for that year. The suspended loss will be treated as qualified business net loss carryover from a separate trade or business in the year the loss is allowed for purposes of determining taxable income.
For example, Taxpayer A owns rental property that rises to the level of a section 162 trade or business. The rental property generates a $20,000 net loss in Tax Year 2018. The loss would be includable in QBI in Tax Year 2018 if it were not fully limited by section 469, passive activity loss limitations. The $20,000 loss is not included in the calculation of taxable income in Tax Year 2018, so it is not included in A's QBI for Tax Year 2018. However, if the loss is allowed for use in computing A's Tax Year 2019 taxable income, the loss will be treated as qualified business net loss carryover from a separate trade or business and will be used to calculate A's Tax Year 2019 QBI deduction.
Do I need to file information returns, such as Form 1099-MISC, if I take a QBI deduction from income generated by my rental property?
As provided in section 6041, persons engaged in a trade or business and making payment in the course of such trade or business to another person of $600 or more in any taxable year may be required to file an information return reflecting the details of such transactions. Application of section 199A and its rules do not change any existing requirement for information reporting as provided under section 6041.
Triple net leases do not qualify for the safe harbor provision. Does this mean that income, gains, deductions and losses from a triple net lease can never be included in QBI?
No. As explained previously, rental real estate is treated as a trade or business for purposes of the QBI deduction if it rises to the level of a section 162 trade or business, is a self-rental or is a rental real estate enterprise. Revenue Procedure 2019-38 only excludes triple net leases from being included in a rental real estate enterprise (and are therefore not eligible for the safe harbor).
A single triple net lease does not generally rise to the level of a section 162 trade or business. However, if rental real estate involving a triple net lease is otherwise treated as a trade or business under section 199A, then the income, gains, losses and deductions would be included in QBI.
If real estate is rented to a Specified Service Trade or Business (SSTB), does that mean the rental real estate is also considered an SSTB?
It depends. If real estate is rented to a commonly owned SSTB (trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners.), meaning 50 percent or more common ownership including direct or indirect ownership by related parties, the portion of real estate rented to the commonly owned SSTB is a separate SSTB with respect to the related parties, only. Any portions not rented to the commonly owned SSTB, as well as any interests held by an unrelated party, would not be a SSTB.
For example, Taxpayer A owns 100 percent of a commercial office building and leases the entire building to an S corporation, of which Taxpayer A is a 50 percent shareholder. The lease of the building is treated as a trade or business for purposes of section 199A under the self-rental rule. S corporation operates a medical practice which is an SSTB. The lease of the building to the S corporation is treated as a separate SSTB of Taxpayer A.
If real estate is rented to a C corporation, are the income, gain, deduction and losses from the rental QBI?
It depends. Rentals to a C corporation can generate QBI if the rental real estate is conducted by an individual or a relevant passthrough entity (RPE) and is a section 162 trade or business or a rental real estate enterprise. The self-rental rule does not apply to rentals to C corporations.
The Bottom Line
An examination of the stringent requirements necessary to qualify for the QBI for realtors, it is very likely that very few realtors will qualify for this tax deduction.