In December 2019, the IRS created a safe harbor for rental real estate businesses to qualify for the 20% qualified business income (QBI) deduction. Now the IRS has issued new FAQs that explain how real estate companies that do not meet the strict requirements of the safe harbor can nonetheless get the QBI deduction.
Under the IRS’s new guidance, rental real estate is treated as a trade or business for purposes of the QBI deduction if it meets these requirements:
- Trade or business. The rental real estate rises to the level of a Code Sec. 162 trade or business; or
- Self-rentals. The rental or licensing of property is to a commonly controlled trade or business operated by an individual or a passthrough entity. To be considered commonly controlled, there must be 50% or more common ownership.
Whether an activity is a trade or business under Code Sec. 162 depends on all of the facts and circumstances. The IRS makes this determination in many different contexts and uses numerous factors, with the primary one being the intent to make a profit. For real estate activities, other important factors are:
- Where the business activity is considerable, regular, and continuous.
- The type and amount of rented property (commercial vs residential property).
- The extent of the owner’s involvement in the business.
- The types and amounts of services provided under leases and the terms of the leases.
Rental real estate that is a trade or business and self-rentals can be aggregated with other trades or businesses, including other rental real estate businesses.
Triple Net Leases
Triple net leases specifically do not qualify for the safe harbor but can still qualify for the QBI deduction. The IRS’s FAQs explain that, if rental real estate involving a triple net lease is otherwise treated as a trade or business under Sec. 199A, the QBI rules, then the income, gains, losses and deductions would be included in QBI.
No Material Participation Necessary
Taxpayers do not have to materially participate in their businesses to get the QBI deduction. (The material participation rules apply to distinguish between active and passive business activities.) Eligible taxpayers with income from a qualified trade or business can get the QBI deduction regardless of their level of involvement in the business. Note, however, that the level of a taxpayer’s involvement in a business is one factor to be considered when evaluating whether the taxpayer is conducting a trade or business.
Renting to Service Businesses and Corporations
You may recall that many service businesses were excluded from QBI. These include professional service firms where reputation or skill is the main asset of the business—so-called “specified service trade or businesses (SSTBs).”
The IRS FAQs raise the question of whether real estate rented to a commonly owned SSTB qualifies for the QBI deduction. The answer is maybe. Any portions rented to a commonly owned SSTB do not qualify, but portions not rented to a commonly owned SSTB, as well as any interests held by an unrelated party, may qualify.
Example: Taxpayer A owns 100% of a commercial office building and leases the entire building to an S corporation, of which Taxpayer A is a 50% shareholder. The lease of the building is treated as a trade or business for QBI deduction purposes under the self-rental rule. The S corporation operates a medical practice which is an SSTB. The lease of the building to the S corporation is treated as a separate SSTB of Taxpayer A subject to the restrictions on service businesses.
Although C corporations do not qualify for the deduction, rentals to a C corporation can generate QBI if the rental real estate is conducted by an individual or a relevant passthrough entity and is a Sec. 162 trade or business or is qualified under the safe harbor. Self-rental income received from a C Corporation does not qualify, however.
Form 1040 Reporting and Self-Employment Tax
The IRS also addressed how to report rental real estate activities and whether the income is subject to the self-employment tax. Rental real estate income should continue to be reported on Schedule E, Part 1 and is not subject to self-employment tax. However, some rental activities, such as hotel or motels and bed and breakfasts, may be subject to self-employment tax if substantial services are rendered for the convenience of the occupants. Rental real estate activities subject to self-employment tax are reported on Schedule C.
A Reminder of the Rental Real Estate Safe Harbor Requirements
Only individuals are qualified for the rental real estate safe harbor. Corporations and partnerships are not eligible, but shareholders of an S corporation or the partners in a partnership or LLC can qualify. The following requirements must be met by taxpayers to qualify for the safe harbor: