Does Rental Real Estate Qualify for the QBI Deduction?

Does Rental Real Estate qualify for the 20% QBI Deduction? 

Yes, rental real estate can be eligible for the Qualified Business Income (QBI) deduction under certain conditions. The QBI deduction, also known as the Section 199A deduction, allows eligible taxpayers to deduct up to 20% of their qualified business income from a qualified trade or business, including income from rental real estate, subject to certain limitations.

Conditions for Rental Real Estate to Qualify for QBI Deduction:

Trade or Business Requirement: The rental activity must rise to the level of a trade or business. This generally means the rental activity should be conducted with continuity and regularity, and the primary purpose should be for income or profit. Occasional or sporadic rental activities may not qualify.

The Safe Harbor Rule: The IRS has provided a “safe harbor” rule under Revenue Procedure 2019-38, which helps determine if rental real estate qualifies as a trade or business for the QBI deduction:

(a) Separate Books and Records: The rental real estate must maintain separate books and records to track income and expenses for each rental real estate enterprise.

(b) 250 Hours of Rental Services: The taxpayer must perform 250 or more hours of rental services per year for the enterprise, which can include time spent by owners, employees, agents, and independent contractors.

(c) Contemporaneous Records: The taxpayer must keep contemporaneous records, including time reports, logs, or similar documents, to substantiate the hours of rental services performed.

(d) Exclusion of Triple Net Leases and Vacation Rentals: The safe harbor does not apply to triple net leases or rental properties used by the taxpayer for any part of the year as a residence (e.g., vacation homes).

Aggregation of Properties: If you have multiple rental properties, you can elect to aggregate them as a single trade or business to meet the QBI requirements. This is particularly useful if the properties individually do not meet the 250-hour requirement but collectively do.

REIT Dividends and Publicly Traded Partnerships:

Rental income received from Real Estate Investment Trusts (REITs) or Publicly Traded Partnerships (PTPs) can also qualify for the QBI deduction.

Income Limitations:

The QBI deduction is subject to income thresholds. For taxpayers with taxable income above certain limits ($364,200 for married filing jointly and $182,100 for other filers in 2024), the deduction may be limited or phased out, especially for specified service trades or businesses (SSTBs).

Self-Rental:

If you rent property to a business that you materially participate in and own, the rental income may qualify for the QBI deduction as long as the rental activity meets the trade or business requirement.

Building appreciation, reducing mortgage costs, generating cash flow, and leveraging rental losses through tax returns can be powerful tools when applied correctly. Here’s the good news: If your property investments yield positive net rental income, that income is eligible for the 20% 199A deduction.

However, most real estate investors, especially those using leverage, typically experience a net loss due to depreciation and mortgage interest (which is paid by the tenant). The downside? Under the 199A regulations, if you incur a net loss, it must be combined with your other positive QBI income, thereby reducing the 199A deduction you might have otherwise received from a different business. That’s frustrating!

To illustrate this challenge, let’s say you have $50,000 in rental losses and $50,000 in K-1 profit from your operational S-corp business. You might expect that the 20% deduction would provide a $10,000 write-off ($50,000 of QBI x 0.20). However, the rental losses offset the $50,000, reducing your QBI to zero. As a result, no deduction is available!

While the losses from your real estate investments might negatively impact your total QBI and reduce the 20% deduction, they can still be beneficial for income tax purposes, especially for real estate professionals. For instance, if the $50,000 in rental losses offsets the $50,000 in business income, reducing your QBI to zero, you can still lower your Adjusted Gross Income (AGI). This reduction in AGI can result in significant income tax savings. If you or your spouse are classified as a real estate professional, these losses can continue to provide tax benefits.

Summary:

Rental real estate can qualify for the QBI deduction if it meets the criteria of a trade or business. Utilizing the IRS safe harbor rule can help ensure compliance, but it’s essential to keep detailed records and understand the specific requirements. Consulting with a tax professional is advisable to determine eligibility and optimize your QBI deduction.