One of the most significant changes under the Tax Cuts and Jobs Act is Section 199A Qualified Business Income deduction. In laymen’s terms, this is a 20% deduction for sole proprietorships and pass-through entities on their net business income. For farmers, sole proprietors (schedule C) and other pass through entities (S corps and partnerships) that actively engage in business for profit there is no question that the business activities qualify for QBI. As long as there is profit and taxable income for the deduction, these business owners qualify for the QBI deduction.
When it comes to rental property, qualification for the QBI deduction is not as clear. Taxpayers who have residential rentals, commercial rentals, or 4835 farm rentals need to determine whether their rental activity is a trade or business qualifying for QBI. Some rental activities will be considered trades or businesses qualifying for QBI and others will not meet the requirements.
As a taxpayer with rental property how do you determine if you qualify for a QBI deduction? Unfortunately, the IRS has not made it completely clear for every situation. However, there are a few situations that are spelled out clearly in Notice 2019-07. I’ll start with the clear policies:
Rental Activities that Do NOT qualify:
- Triple net leases. This is a lease agreement that requires the tenant to pay taxes, fees, and insurance, and to be responsible for maintenance activities in addition to rent and utilities. Essentially, any agreement where the owner just collects a check and all the responsibility falls on the tenant will not qualify for QBI. (For this reason, we believe that farm cash rent arrangements where the owner does not provide services or share in expenses will NOT qualify for QBI.)
- Real Estate used by the taxpayer as residence for any part of the year. (Think vacation homes or time shares that owners spend a few weeks living in and rent out the rest of the year. These will NOT qualify.)
Rental activities that WILL qualify under Notice 2019-07 safe harbor:
To guarantee that you qualify for the QBI deduction, you must meet these qualifications:
- Separate books and records that reflect income and expenses for each rental activity. (Commercial, residential and farm rentals must all be separate activities. If you have multiple residential properties you can group those as one to qualify for QBI. Similarly, if you have multiple farm rental properties or commercial buildings—the rental real estate in the same category can be grouped as one.)
- Taxpayers must perform 250 or more hours of rental services per year for each rental activity.
- Taxpayers must keep contemporaneous records, including time reports, logs or similar documents with all of the following information:
- Hours of all services performed
- Description of all services performed
- Dates the services were performed
- Who performed the services
What are the implications for a taxpayer with rental property?
As you can see from the safe harbor requirements you are going to have to keep a record of all of your rental service activity. What services count toward the 250-hour safe harbor? Here they are:
- Advertising to rent or lease the property
- Negotiating and executing leases
- Verifying information in prospective tenant applications
- Collection of rent
- Daily operation, maintenance and repair of the property
- Management of the real estate
- Purchase of materials
- Supervision of employees and independent contractors*
*Log time employees, contractors, or agents spend on these activities as well
The IRS also specifically spelled out services that DO NOT count toward the safe harbor. The following financial or investment management activities DO NOT count:
- Arranging financing
- Procuring property
- Studying and reviewing financial statements on operations
- Planning, managing or constructing long-term capital improvements
- Hours spent traveling to and from the rental property
What if I track all my time and don’t meet the 250 hours? Does that mean I don’t get QBI?
Not necessarily. This is the part that is unclear. The IRS does not say you do not get QBI, however, the burden of proof is on you to prove it to them if you fall under 250. Over 250, you are safe (thus the term “safe harbor.”) At under 250 hours, you will potentially have to make your case to the IRS and they could rule either way. In fact, experts expect rulings to come down in the coming years to eventually clear up what qualifies and what doesn’t.
What should I do if I am under 250 hours? Should I be conservative and forget about QBI, or should I be aggressive and go for it—hoping to prove I am engaged in the IRS definition of trade or business?
Since there are not clear guidelines, the best we can do is speculate how the IRS will view certain rental situations. Here are some rules of thumb that we think you can use until more guidance and court cases set precedents:
- The more properties you have and the more time you spend, the more likely you can make an argument—even if you fall slightly short of 250 hours
- If you are a 4835 crop-share landlord who pays a significant portion of expenses, we lean toward going for QBI—especially if you provide services, hire contractors for maintenance, etc.
- If you only have one property and do not spend very much time on operations, it is best to lean on the conservative side and not claim QBI
- If you continually have very low profits (or losses) on your rental property, it will probably not be worth it to track all of the time for the amount of deduction you will get
Summary and next steps for taxpayer with rental income:
If you make good profits from your rentals and spend a significant amount of time managing them (or pay employees or contractors to do a lot of work on your properties), you may qualify for QBI on your rentals. In order to claim the QBI deduction you will want to begin keeping a contemporaneous log of all your activity. You can pick up our rental services log spreadsheet at the office or download our excel version on the resources section of our website (www.sewardcpa.com).
You will want to go back and document any activity since January 1, 2019 and be sure to keep a contemporaneous log going forward. Please let us know if you have any questions. We would be happy to discuss your rental activity with you and help you make a determination if you will qualify for QBI. Qualifying for the QBI deduction could save you some good money in future years. Please let us know any way we can help or be of service to you!