There are three avenues for a rental real estate activity to be considered a trade or business eligible to generate QBI:
(1) the rental activity qualifies as a Sec. 162 trade or business,
(2) it rents to specific related parties; or
(3) it satisfies the requirements of a proposed safe harbor.
SEC. 162 Trade or Business
Case law provides that a Sec. 162 trade or business entails a profit motive and requires considerable, regular, and continuous activity. Several factors are analyzed to determine whether a rental real estate activity is a Sec. 162 trade or business:
The type of property rented (commercial versus residential)
The number of properties rented
The owner's (or the owner's agents') day-to-day involvement
The types and significance of any ancillary services provided under the lease, and
The terms of the lease (e.g., a net versus a traditional lease and a short-term versus a long-term lease)
Special Rules for Self Rentals
Under specific circumstances, a rental activity that rents to a related person is deemed a trade or business for QBI purposes.
1) The activity must rent or license property to an individual or passthrough entity that is commonly controlled, which means the same person or group of persons owns at least 50% of the rental activity and the related trade or business, and
2) The related party cannot be a C corporation under this rule
SSTBs include businesses in the field of health; law; consulting, financial services, amount others where the principal asset of the trade or business is the reputation or skill of one or more owners or employees.
Income derived from renting real estate to a specified service trade or business (SSTB, which is not a qualified trade or business under Sec. 199A(d)(1)(A)) treated as income from an SSTB and therefore may be partially or fully excluded from QBI.
An individual whose income exceeds a taxable income threshold of $464,200 (MFJ) or $232,100 (S & HH) cannot take income from an SSTB into account in calculating the QBI deduction. MFJ filers with taxable income between $364,200 and $464,200 and single & head of household filers with taxable income between $182,100 and $232,100 may qualify for a percentage of the QBI deduction, as they are subject to phase-out rules.
An Example
Partnership “A” exclusively rents office space to S-corporation “B”, a medical office.
“A” and “B” have the same ownership – the arrangement is a self-rental.
The net rental income Partnership A receives is specified service trade or business income (SSTB) Qualified Business Income (QBI) since B is a specified service trade or business (SSTB) and the two entities are commonly owned.
Safe Harbor
The IRS issued Notice 2019-07 concurrently with the final QBI regulations. It provides proposed safe-harbor requirements for a rental real estate activity to qualify as a trade or business for QBI purposes. The safe harbor does not need to be satisfied if the rental activity is otherwise considered a Sec. 162 trade or business or satisfies the related-party rental rule.
There are a number of provisions an activity that is not considered a Sec. 162 trade or business must satisfy to meet Safe Harbor requirements, including:
Separate books and records must be maintained for the rental real estate activity
For tax years beginning prior to Jan. 1, 2023, at least 250 hours of rental services must be performed each year with respect to the rental activity by owners, employees, agents, and/or independent contractors
Contemporaneous records of services performed must be maintained for tax years beginning on or after Jan. 1, 2019
Real estate rented under a triple net lease in which the tenant or lessee pays for taxes, fees, insurance, and maintenance is not eligible for the safe harbor;
Real estate activities are not considered a trade or business if real property is used as a residence as defined in Sec. 280A, and
A statement signed under penalties of perjury must be attached to the taxpayer's tax return that indicates the safe harbor has been satisfied.
Summary
Although classifying a rental activity as a trade or business that generates QBI may seem preferable, many rental activities generate losses for tax purposes due to depreciation, and thus may produce negative QBI, which is likely detrimental for tax purposes.
Negative QBI offsets positive QBI from other sources and potentially carries over to subsequent years. Therefore, careful consideration should be made in classifying a rental activity that generates losses as a trade or business for QBI purposes.
If you plan to engage in a self-rental activity such as owning a business that owns real estate and have rented the property to another business you own it is essential to discuss the arrangement, your financial and tax structures and your goals with a CPA | Tax Advisor in advance to ensure you understand your options and the tax implications of in advance. Locking yourself into an arrangement that is not best suited to your needs and/or an arrangement that may not be tax efficient can be expensive - and is unnecessary.
If you have any questions or would like to schedule a consultation to discuss your situation, reach out to get our conversation started.
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