In addition to the high returns and capital appreciation, real estate has another great thing going for it: exceptional tax advantages. Capital gains are taxed at 0%, 15% or 20%, depending on your income, which is a significantly lower rate than regular income tax.
There are also a number of real estate expenses that are tax-deductible, including mortgage interest, property taxes, property insurance, and ongoing maintenance and repairs. And then there’s QBI, or the Qualified Business Income deduction, which can provide investors with the opportunity to save 20% on taxes.
But the dedication can be confusing. Is rental income qualified business income? Who qualifies for it? How does the QBI deduction work and how can you claim it? We answer these questions and more in today’s article.
What is qualified business income (QBI)?
Qualified Business Income or QBI is the net amount of qualified items of income, gain, deduction and loss from any qualified trade or business, according to the IRS. This includes income from partnerships, S corporations, sole proprietorships, and certain trusts. Generally, it includes, but is not limited to, the deductible part of self-employment tax, self-employment health insurance, and deductions for contributions to qualified retirement plans.
To put it simply, qualified business income is the net income generated by any qualified trade or business under Internal Revenue Code (IRC) § 162. However, QBI excludes:
- Capital gains or losses
- Interest income
- Shareholder wages
- Income earned outside the US
- Guaranteed payments made to partners
The Qualified Business Income Deduction or Section 199A deduction is a tax deduction that allows eligible self-employed and small business owners to deduct up to 20% of their qualified business income on their taxes. For 2021, the taxable income had to be under $164,900 for single filers or $329,000 for joint filers to qualify. In 2022, that’s increased to $170,050 for single filers and $340,100 for joint filers.
Here’s why this matters to real estate investors: Rental properties are typically treated as passive entities and are, therefore, excluded from the definition of a qualified trade or business. However, rentals that qualify as trades or businesses under § 162 aren’t considered passive, thereby potentially qualifying them for the purposes of the QBI deduction.
Is rental income qualified business income?
The Tax Cuts and Jobs Act (TCJA) of 2017 added a new deduction from business income referred to as the Qualified Business Income Deduction or Section 199A. In 2019, further clarification was provided and updates were made to allow a safe harbor for rental income to be eligible for the 20% deduction. Not all rental income qualifies and there are limitations, the largest one being that the qualified business income must come from a “pass-through”’ real estate entity that is not taxed at the corporate level.
A pass-through business in real estate is an entity that passes income and expenses from a rental property through to the individual taxpayer. Similar to other pass-through entities, such as limited liability companies and sole proprietorships, they do not pay taxes at the corporate level. Instead, any taxable income is reported on an individual’s tax return, thereby avoiding double taxation.
Pass-through business entities used in real estate include:
- S corporation
- Limited liability company (LLC)
- Limited partnership (LP)
- Sole proprietorship
- Estate
- Trust
- Publicly traded partnership (PTP)
- Real estate investment trust (REIT)
Passive rental activities where landlords or owners have minimal contact with a tenant, that is, collecting rent or maintenance of the property, must be excluded from the QBI deducted. In 2019, a new “safe harbor” provision was introduced for rental properties through which investors could 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).
How does the QBI deduction work for rental real estate?
Let’s use a simple example to see how this works. Let’s say you’ve earned an additional $2,000 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, for the sake of this example, that you’re in the 24% tax bracket.
Now your regular income from the job will be taxed at your ordinary income tax rate of 24%, which means you’ll pay $240 in taxes for that $1,000 earned. (24% of 1,000 = 240).
Tax paid on job income = $240.
Now, let’s look at that $1,000 in dividends. Because Arrived properties are set up as REITs, which qualifies them for the QBI, you can immediately deduct 20% tax-free. This means that you’re now left with a taxable income of $800 and you’ll pay 24% on this sum, that is, $192.
Tax paid on Arrived income: $192.
Effectively, what this means is that you’re paying only 19.2% tax on your Arrived income, but 24% of tax on earned income from a job. And this is what makes QBI so attractive to real estate investors.
Who can claim the deduction?
To qualify for a QBI deduction, a rental property must qualify as an RREE or a rental real estate enterprise. This means that the primary purpose of this rental business must be to hold a real property and generate a profit. Each rental property or group of properties must also:
Maintain books
Each rental real estate enterprise must maintain separate books and records to reflect income and expenses.
Keep service records
The IRS also specifies that the taxpayer must maintain contemporaneous records, including time reports, logs, or similar documents regarding the following:
- Hours of all services performed.
- Description of all services performed.
- Dates on which such services were performed.
- Who performed the services.
Perform minimum rental services
For rental real estate enterprises that have been in existence for less than four years.
For the purposes of the QBI safe harbor requirements, services include rental real estate activities such as:
- Collecting and depositing rent
- Marketing the property
- Tenant selection and background checks
- Negotiating and executing leases
- Day-to-day maintenance, operations, and repairs of the property
- Purchasing materials and coordinating with vendors
- Property management, including supervision of employees and contractors
Rental services can be performed either by owners of the property or their employees, independent contractors, or agents. Tasks that are not considered rental services include traveling to and from a rental property, capital improvements on the property, and reviewing financial statements.
There are also certain property types that are not eligible for the safe harbor deduction. These include:
- A property that is used as a specified service business.
- A property that’s used as a residence during any part of the year, such as a property you’ve rented to yourself or a vacation rental or second home.
- Properties on a triple-net lease, where the tenant is required to pay taxes, utilities, maintenance and insurance.
- Rental property located outside of the U.S.
- Land rentals, for example, agricultural land leased to a farmer.
How to claim the QBI deduction
As per IRS guidelines, real estate used by a taxpayer as a residence for any part of the year under section 280A is not eligible for safe harbor. Taxpayers are not allowed to vary this treatment from year to year, unless there has been a significant change in circumstances. Additionally, commercial and residential real estate should not be part of the same enterprise for purposes of meeting this safe harbor.
As per IRS guidance, the relevant forms from this list must be submitted:
- Form 1040, U.S. Individual Income Tax Return;
- Form 1040-NR, U.S. Nonresident Alien Income Tax Return;
- Form 1040-SR, U.S. Tax Return for Seniors;
- Form 1041, U.S. Income Tax Return for Trusts and Estates;
- Form 1065, U.S. Return of Partnership Income; or
- Form 1120S, U.S. Income Tax Return for an S Corporation
The Form 8995 used to complete the S portion’s QBI deduction must be attached as a pdf to the ESBT (Electing Small Business Trust) tax worksheet filed with Form 1041. Form 8995 is for taxpayers whose taxable income before the qualified business income deduction doesn’t reach the threshold. Most other taxpayers claiming the pass-through deduction must use 8995-A. It’s always a good idea to work with a certified financial professional or CPA when doing complicated taxes.
Easily invest in rental homes
Arrived properties are structured as REITs or real estate investment trusts, which qualify as a passthrough entity and are therefore eligible for the QBI deduction. This means that when you invest in a rental property 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. Browse through our available properties on this page and sign up to Arrived Homes to start investing in rental properties today.
The opinions expressed in this article are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security or investment product. The views reflected in the commentary are subject to change at any time without notice. View Arrived’s disclaimers.
