Noncorporate owners may be eligible for a deduction of up to 20% of the qualified business income (QBI) from a pass-through business entity, including interests in sole proprietorships, partnerships, limited liability companies (LLCs) and S corporations. For 2018 through 2025, this deduction is available to individual owners, as well as estates and trusts.

Numerous rules and restrictions apply to this lucrative tax break. In fact, confusion over the QBI deduction and other tax law changes under the Tax Cuts and Jobs Act caused a record number of small business owners to file for extensions last tax year. Fortunately, the IRS issued additional guidance in 2019 that helps clarify whether this deduction applies to income from real estate entities.

Safe-Harbor Rules

Under a safe-harbor rule that was finalized in September 2019, income from an eligible rental real estate enterprise is classified as QBI. To be eligible for the safe harbor, an ownership interest in real property must be held for the production of rents. It may consist of ownership interests in multiple properties.

In addition, the real property can be owned directly by an individual, estate or trust. Or it can be owned indirectly by an individual, estate or trust through a relevant pass-through entity (RPE). An RPE is a partnership, an LLC treated as a partnership for tax purposes, or an S corporation.

Each ownership interest can be treated as a separate rental real estate enterprise — or all interests in similar properties (either residential or commercial) can be combined and treated as a single rental real estate enterprise. Mixed use property may be treated as a separate enterprise or bifurcated into separate residential and commercial interests.

As a result, an interest in commercial rental real estate can be combined only with one or more other interests in commercial rental real estate. Likewise, an interest in residential rental real estate can be combined only with one or more other interests in residential rental real estate. In addition, taxpayers can’t vary how they treat properties from year to year unless there’s a significant change in facts and circumstances.

Two types of property are generally ineligible for the safe harbor, unless a special “self-rental” exception applies. First, real estate that’s used personally by the taxpayer (such as a primary residence) is ineligible. Second, properties rented under a triple net lease are generally ineligible for the safe harbor. A tenant under a triple net lease pays all expense related to the property, including utilities, taxes, fees, insurance and maintenance.

Separate books and records must be maintained for each rental real estate property and may be consolidated for reporting purposes of a rental real estate enterprise.

Hours of Service

Taxpayers must use an “hours-of-service” test to determine whether income from a property counts as QBI. Specifically, for a rental real estate enterprise that’s been in existence for fewer than four years, at least 250 hours of rental services must be performed each year. For a rental real estate enterprise that’s at least four years old, at least 250 hours of rental services must be performed during each of any of three of the five consecutive tax years that end with the current tax year.

For purposes of passing the hours-of-service tests, examples of rental services include:

• Advertising rental properties,
• Negotiating and executing leases,
• Verifying information contained in prospective tenant applications,
• Collecting rents,
• Maintaining, repairing and managing properties,
• Purchasing materials, and
• Supervising employees and independent contractors.

Ineligible Activities

You might be surprised that some services provided for real estate entities don’t qualify toward the hours-of-service test. Examples of nonrental activities include:

• Arranging financing,
• Acquiring property,
• Studying and reviewing financial reports,
• Planning and making long-term capital improvements, and
• Traveling to and from properties.

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The final safe-harbor guidance generally applies to tax years ending after December 31, 2017. However, new, more-detailed record-keeping requirements to support the hours-of-service test go into effect for tax years starting January 1, 2020. The taxpayer bears the burden of proving the right to the deduction.

Contact us to determine whether you’re up to date with these requirements. Attempting to re-create records at year end is a painstaking process. Our tax services professionalscan help developers and investors understand the safe-harbor rules and start off the new decade on the right foot.