Whether you’re a real estate investor, a freelancer, or the owner of an LLC, you’ll need to understand not only how your personal taxes work but how your business plays into the money you owe the IRS each year.
In the US, most businesses are classified as “pass-through” businesses, which means the business income passes through to the owners, who are then taxed through their individual tax returns. Pass-through businesses include sole proprietorships, partnerships, limited liability companies (LLCs), and S corporations, but not C corporations.
If you have a pass-through business, the Tax Cuts and Jobs Act of 2017 allows your business a valuable tax break: The Qualified Business Income Deduction.
In this article, we’ll talk about Qualified Business Income Deduction—what it is, how to know whether your business is eligible, and how to claim it as a US taxpayer.
What is Qualified Business Income Deduction?
The Qualified Business Income (QBI) deduction or Section 199A is a tax deduction that was added to the US tax code by the Tax Cuts and Jobs Act (TCJA) in 2017. It offers a potential business deduction to businesses with pass-through income by allowing them to write off up to 20% of a taxpayer’s taxable income.
To understand the Qualified Business Income deduction, it’s important to understand two important terms:
- Qualified Business Income: The IRS defines QBI as “the net amount of qualified items of income, gain, deduction, and loss from any qualified trade or business, including income from partnerships, S corporations, sole proprietorships, and certain trusts. These includable items must be effectively connected with the conduct of a trade or business within the United States.” Basically, if it’s business income from any of the above business types, it’s QBI. However, capital gains or losses, dividends, interest income, annuities received from something other than business, guaranteed payments from a partnership, and income earned outside the US does not count towards QBI. You can read through the QBI FAQs on the IRS website.
- Pass-through income: Pass-through income is generated through a business that is then passed on to the owners without being taxed at the entity level. If you’re a sole proprietor, for instance, the income your business generates is not subject to corporate or business tax but, instead, is passed on to you, the owner, who is then taxed individually. A business of this nature is referred to as a pass-through entity.
What makes the Qualified Business Income Deduction so appealing is that it allows business owners who pay self-employment tax to write off up to 20% of their taxable income, ultimately lowering the amount of federal income tax they pay in a given year. Both standard deductions and itemized deductions will qualify you for QBI.
Who qualifies for the QBI deduction?
A few conditions need to be met to qualify for a QBI deduction. Not every business will be eligible, and some income thresholds also need to be considered.
Business owners with pass-through income
As we’ve discussed, business owners with pass-through entities can qualify for the QBI deduction. This includes businesses such as:
- Sole proprietorships: A single individual who could be a freelancer, an independent contractor, or an unincorporated business is considered a pass-through entity.
- Partnerships: A partnership is a business organization run by two or more people who share responsibility for the running and operations of the business.
- S corporation: S corps are business structures designed to pass their taxable income, credits, deductions, and losses directly to their shareholders. An S corp must have 100 or fewer shareholders.
- Limited Liability Company: A Limited Liability Company or LLC is a business structure that, while not a corporation, combines the pass-through taxation benefits of a sole proprietorship or partnership with a corporation’s limited liability and protections.
Qualified REIT dividends or PTP income
If you have qualified dividends from a Real Estate Investment Trust (REIT) or income from a Publicly Traded Partnership (PTP), you’re also eligible to claim a 20% QBI deduction. Qualified REIT dividends must have been held for more than 45 days and don’t include capital gains or regular qualified dividends.
Specified Service Trade or Business (SSTB)
The QBI deduction is only available to owners of pass-through businesses. However, if your business is a Specified Service Trade or Business, you can only avail of the QBI deduction up to a specific taxable income limit. The limits change each year, and these are complex calculations, so it can be helpful to work with a tax advisor to see if your business qualifies for the QBI deduction.
According to the IRS, “an SSTB is a trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading or dealing in certain assets, or any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners.” This is to say; if the income of the business, typically a service business, depends on the owner’s abilities to perform a certain job, it qualifies as an SSTB.
How to calculate and claim the QBI deduction
The QBI computation can get complicated quickly, so it may help to work with a tax professional or CPA to calculate the QBI deduction and prepare your paperwork. Here are the steps you’ll need to follow.
- Determine whether your business is an SSTB: You’ll need to work out if your business qualifies as a Specified Service Trade or Business since the requirements for your business will differ based on the answer to that question.
- Calculate your gross and taxable income for the year: If your taxable income is less than a certain threshold amount, then you can take the full 20 percent regardless of the type of business. This threshold is $170,050 in 2022 for single filers and $340,100 if married filing jointly. However, if your business is an SSTB, and your income is more than $220,050 if you’re a single filer and $440,100 if you are married and filing jointly, you will not qualify for the QBI deduction. For SSTBs that have a total taxable income in the phase-out range, that is, between $170,050 and $220,050 ($340,100 and $440,100 for married joint filers), you’ll need to calculate your qualified business income and apply the limitation of:
- 50% of your share of W-2 wages paid by the business, or
- 25% of those wages, plus 2.5% of your share of qualified property
- Your combined QBI is then compared to 20% of the excess of your taxable income over your net capital gain
- Claim the deduction: You must fill out forms 8995 or 8995-A to apply for your QBI deduction. The IRS provides detailed instructions on how to fill out the form and attach it to your tax return and Schedule C form.
Is rental income qualified business income?
In 2019, a new “safe harbor” provision was introduced for rental properties through which investors can qualify for the QBI deduction if all rental activities are a trade or business and operate in the form of a rental real estate enterprise (RREE). Passive rental activities, for example, where landlords have minimal contact with a tenant, are not included in the QBI deductions.
Let’s illustrate how this works through a simple example. Let’s say you’ve earned an additional $5,000 for the tax year, half from qualifying dividends from your investment in Arrived properties, and the other half from your day job. Let’s also assume that you’re in the 22% tax bracket.
In this example, your regular income from your job will be taxed at the ordinary income tax rate. So you’ll pay:
22% of $2,500 = $550
Now let’s look at the other $2,500 in dividends. Our properties at Arrived are set up as REITs, which qualifies them for the QBI. So you can immediately deduct 20% tax-free. This means that you’re now left with a taxable income of $2,000, and you’ll pay:
22% of $2,000 = $440
That’s a saving of $110 right at the source. And these savings are what make QBI so attractive to business owners and real estate investors.
Do note: If you recently bought a partnership interest in a real estate business, there will be a limit to the QBI deduction, and you’ll need to calculate the percentage of the unadjusted basis immediately after acquisition (UBIA).
The bottom line
The QBI is an excellent tax deduction for small business owners with pass-through income and is essential to understand both from the business and tax savings perspective, as well as when considering your retirement plan.
Arrived’s long-term rental properties are structured as REITs, which qualify as pass-through entities and are therefore eligible for the QBI deduction. This means that when you invest in an LTR through Arrived, not only are you able to take advantage of the lower barrier to entry but also get access to the 20% QBI tax deduction. Please browse our available properties on this page and sign up for an account to start investing in rental properties today.