The QBI Deduction And Rental Income

Are you wondering, “is a rental property qualified business income?” Rental income can often qualify for the Qualified Business Income (QBI) deduction if certain requirements are met. The deduction, which was implemented under the Tax Cuts and Jobs Act of 2017, allows qualified taxpayers to exclude up to 20% of qualified business income from their tax base. However, not all rental activity is eligible, and certain requirements must be met for you to benefit from this deduction.

Understanding Qualified Business Income

Qualified Business Income refers to the net income derived from a qualified trade or business, excluding items like capital gains, interest, and dividends. Many owners of sole proprietorships, partnerships, S corporations, and some trusts and estates may be eligible for the QBI deduction. The deduction is available for tax years beginning after December 31, 2017, and allows eligible taxpayers to deduct up to 20% of their QBI, plus 20% of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income.

It’s also important to note that the QBI deduction expires on December 31st, 2025, unless Congress agrees to extend it.

Understanding Rental Income

Rental income includes any amount received for the use or occupation of property. This includes monthly rent payments and other payments like advance rent, security deposits applied towards a previous month's rent, and tenant-paid expenses that are normally the landlord's responsibility. All rental income is required to be reported on your tax return under Schedule E, and, in most cases, the related expenses can be deducted from your rental income.

Overview of the QBI Deduction

What is qualified business income deduction rental property? As stated before, the QBI deduction enables eligible taxpayers to deduct as much as 20% of their qualified business income from their taxable income, and is reported on Form 8995. The deduction is capped by the type of the trade or business (S Corporations, LLCs, etc.), the taxpayer's taxable income, and the amount of W-2 wages generated by the business or the unadjusted basis at acquisition (UBIA) of qualified property in the hands of the business.

The Intersection of Rental Income and QBI

Whether or not rental income is qualified business income (QBI) depends on whether the rental activity amounts to a trade or business as interpreted by the IRS under Section 162 of the Internal Revenue Code. Rental real estate, as opposed to other enterprises, sometimes would be considered passive income, and as such, it would be exempt from the QBI deduction. However, the IRS recognizes that some rental business activities involve considerable business operations or significant services, such as management of tenants, maintenance of leased property, and negotiation of leases, and therefore they can be eligible for QBI treatment.

To provide clarity, the IRS issued detailed guidelines to help you determine whether or not your rental property qualifies as a Sec. 162 trade or a business. One of the guidelines includes the safe harbor rule, which we will discuss next.

IRS Safe Harbor for Rental Real Estate Enterprises

In order to provide guidance, the IRS issued Revenue Procedure 2019-38, offering a safe harbor under which a rental real estate enterprise will qualify as a trade or business for QBI deduction purposes. The safe harbor requirements are: 

• Separate Books and Records: Maintaining separate books and records to account for income and expenses of every rental real estate business
• 250 Hours of Rental Services: Providing a minimum of 250 hours of rental services during a year in the rental real estate business. The owners, employees, agents, or independent contractors can provide these services and include activities such as advertising the property or apartment complex for rent, negotiating and executing leases, screening tenant applications, collecting rents, daily management, maintenance, and repair of the property
• Contemporaneous Records: Maintaining contemporaneous records, like time reports, logs, or the like, of hours of all services performed, nature of services, dates on which such services were performed, and who performed the services

It is worth noting that according to Revenue Procedure 2019-38, certain forms of rental agreements, such as triple net leases and rentals of the taxpayer as a dwelling for any part of the year, are not qualified for this safe harbor.

Determining Business Status Without the Safe Harbor

If a rental real estate company is not eligible and doesn’t satisfy the safe harbor requirements, it may still be considered as a trade or business to become eligible for QBI deduction. The determination hinges on whether the rental activity is carried out on a regular basis and with the main purpose of making income or profit. Factors considered are the nature of property rented out, the size of the property available for rent, the owner or his agent's day-to-day hands-on control, the nature and extent of any ancillary services being provided under the terms of the lease agreement, and the lease terms (e.g., net lease vs. regular lease). Each case is analyzed on its case-specific circumstances.

How to Qualify

To qualify for the QBI deduction of rental income, do the following:

1. Evaluate Your Rental Activity: Assess whether your rental activity is continuous, regular, and operated with the main motive of earning profit or income
2. Proper Documentation: Maintain detailed records of income, expenses, and time allocated towards rental operations. Ensure that you keep separate books and records for every rental real estate business
3. Meet the 250-Hour Requirement: Ensure that you offer at least 250 hours of rental services within the year for each rental real estate business

Once you’ve assessed these qualifications, you will then need to know how to calculate the QBI deduction.

How to Calculate

Calculating the QBI deduction includes the following steps:

1. Calculate Net Rental Income: Subtract allowed deductions (maintenance, insurance, property tax, etc.) from your gross rental income to get your net rental income (NOI)
2. Apply the 20% Deduction: Calculate 20% of your net rental income to calculate your possible QBI deduction
3. Consider Taxable Income Limits: The QBI deduction has a limit of 20% of your taxable income, calculated before the QBI deduction, less net capital gain. So, your deduction may be less than 20% of your QBI if your taxable income is lower

Imagine that you own a single-family rental property that earns $50,000 in gross rental income per year. After deducting $20,000 for insurance, property taxes, and maintenance, your NOI is $30,000.

Since the qualified business income deduction for rental property allows you to deduct 20% of your net rental income, you calculate: 30,000 × 20% = 6,000.

So, you're looking to claim a $6,000 QBI deduction, but the IRS caps the deduction at 20% of your pre-QBI deduction taxable income.

Assume your total taxable income, after deductions, is $25,000. 20% of that is: 25,000 × 20% = 5,000.

You can only claim a $5,000 QBI deduction, although your rental income was eligible for more.

Your last QBI deduction here is $5,000 instead of $6,000 because of the taxable income limit. If you had more taxable income, you would have qualified for the highest deduction. This is why ensuring that you strategize your deductions and income will help you to maximize your QBI benefit and lower your tax bill.

Final Thoughts

The qualified business income deduction for rental property can provide significant tax savings, but not all rental income qualifies. If you’re wondering, “Is my rental property qualified business income?”, it depends on your level of involvement and taxable income limits. Proper planning and documentation can help maximize your deduction and lower your tax bill.

Disclaimer: Ledgre does not provide tax or legal advice. All information and materials available on this site are for general informational purposes only. Contact a tax professional for advice with respect to a specific tax matter.