Several financial benefits are associated with owning rental real estate. Not only do the owners enjoy supplemental income from rent payments, but when treated properly, owning rental real estate may provide opportunities for tax savings. However, classification is important—when rental real estate is classified as a trade or business, rather than an investment, it may qualify for the 20% §199A Qualified Business Income (QBI) deduction. Additional tax savings may be available for taxpayers who qualify as real estate professionals. Read on for an overview of possible deductions and guidance on proper treatment of rental real estate for tax purposes.
Qualifying for Section 199A: Business vs. Investment
The §199A deduction applies to Qualified Business Income (QBI), which comes from an eligible trade or business. Those owners who can classify their rental real estate as a trade or business—not as an investment—may obtain substantial tax savings from the deduction (assuming the business meets other requirements).
The §199A deduction is very broad, but here are a few highlights. Generally, §199A allows owners of sole proprietorships and pass-through entities, such as partnerships, S corporations, and most limited liability companies (LLCs), to deduct as much as 20% of their net business income—itemization not required.
To be entitled to the full 20% deduction, eligible owners’ taxable income must not exceed the inflation-adjusted threshold. For tax year 2022, the thresholds are:
- $170,050 for singles and heads of households
- $340,100 for joint filers
If the owners’ income surpasses the threshold, the deduction may be reduced or eliminated for those businesses that perform certain types of services or lack sufficient W-2 wages or depreciable property.
IRC Section 162: Rental Real Estate as Business
For the purposes of the §199A deduction, the IRS uses Internal Revenue Code (IRC) §162 to determine if an entity qualifies as a trade or business. Rather than providing a strict definition of what comprises “trade or business,” §162 determines qualification on a case-by-case basis. In general, a trade or business activity is one that is conducted “on a regular, continuous and substantial basis” with the intention of earning a profit.
To ease uncertainty over whether rental real estate enterprises (RREEs) qualify as businesses and to establish a safe harbor, the IRS issued Revenue Procedure 2019-38. For a RREE to qualify for the safe harbor offered by the Revenue Procedure, the taxpayer must:
- Maintain separate books and records for the enterprise
- Perform at least 250 hours of rental services per year
- Enterprises that are at least four years old must pass the 250-hour test in at least three of the last five years
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- Keep logs, time reports and other records detailing the services performed
- File a statement with their tax return
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The Revenue Procedure also specifies the types of services which are either included or excluded for purposes of meeting the 250-hour minimum and clarifies that the services can be performed by the owner, employees, or contractors. Further, the Revenue Procedure defines an RREE as one or more of the rental properties held directly by the taxpayer or through disregarded entities (e.g., a single-member LLC). Importantly, certain rental real estate arrangements, such as triple net leases, and those rented to commonly controlled trade or business are not eligible for the safe harbor.
In most cases, taxpayers must treat each rental property as a separate enterprise or treat all similar properties as a single enterprise. For example, a taxpayer cannot combine commercial and residential rental properties in the same enterprise.
Consider Restructuring
To take full advantage of the safe harbor, RREE owners may consider restructuring rental activities. For example, imagine you own a rental residential building and a rental commercial building and perform 125 hours of rental services, per property, per year. As you cannot combine the properties into a single enterprise (under IRC §162), you will not meet the 250-hour requirement.
Then, imagine you exchange the residential building for another commercial building, for which you perform at least 125 hours of rental services. You can now treat your two commercial buildings as a single enterprise, pass the 250-hour test and qualify for the safe harbor (assuming all other requirements are met).
Real Estate Professionals
Aside from the §199A deduction, taxpayers who “materially participate” in a trade or business are entitled to deduct losses against wages or other ordinary income and to avoid net interest income tax on income from the business. The IRS measures material participation through several tests. For example:
- Did the taxpayer devote more than 500 hours to the business per year?
- Did the taxpayer devote more than 100 hours, and no one else participated more?
However, regardless of the time devoted, rental real estate is generally deemed to be a passive activity (one in which the taxpayer doesn’t materially participate). An exception is made, however, for “real estate professionals.” Taxpayers who spend 750 or more hours per year—and more than half of their working hours—on real estate businesses in which they materially participate may qualify for this status. Real estate businesses may include activities such as development, construction, leasing, brokerage and management. Hours spent as an employee do not count, unless the taxpayer owns 5% or more of the business.
Boulay Can Help
Rental real estate tax treatment is complicated, but proper treatment can positively impact your tax bill. For guidance on RREE taxes and to take full advantage of potential tax savings, it’s best to work with a professional. Contact a member of our tax team today at 952.893.9320 or learnmore@boulaygroup.com.