The QBI Deduction for Real Estate Businesses
The Tax Cuts and Jobs Act of 2017 created new Internal Revenue Code (IRC)§199A. Undoubtedly, the new section provides a significant tax break to flow-through entities and structures. Under this new section, subject to certain limitations, taxpayers (excluding C corporations) may be able to deduct up to 20% of the “qualified business income” (QBI) earned in a “qualified trade or business.”1Significantly, this new tax benefit is even available to qualified real estate businesses-but, when does an investment in real estate qualify as a real estate business entitled to the QBI deduction?
What is QBI?
Practically speaking, QBI is the taxpayer’s ordinary income (less ordinary deductions) earned from a passthrough entity or structure. Technically, QBI is “the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer.”2
The first part of the QBI definition refers to “qualified items of income, gain, deduction, and loss” which must be items thatare: (1) “effectively connected”to aU.S. business,”3and (2) included or allowed in determining taxable income for the taxable year.4The second part of the QBI definition references “any qualified trade or business,” which means all trades or businesses, excluding “a specified service trade or business, orthe trade or business of performing services as an employee.”5For purposes of this definition, a “specified service trade or business”
Trade or Business
Clearly, the QBI definition clarifies that the deduction will only apply to a qualified trade or business. Thus, an investment in real estate will only qualify as a real estate business entitled to the QBI deduction, if it is a trade or business.
As for the definition of IRC §199A’s trade or business, the IRS has recently issued proposed regulations which would clarify that:
the definition of a trade or business under section 162 provides for administrable rules that are appropriate for the purposes of section 199A and which taxpayers have experience applying and therefore defining trade or business as a section 162 trade or business will reduce compliance costs, burden, and administrative complexity.6
Unfortunately, although the proposed regulations clarify that the IRS would define an IRC §199A trade or business the same ways it defines trade or business under IRC §162,the IRC §162 definition of “trade or business” has only been developed in the courts and remains subjective. The courts’ definition evaluates the activity for continuity and regularity and requires a bona fide subjective intent to make a profit.7
The courts evaluate these elements by considering all of the facts and circumstances of each case. Some factors used in the analysis may include how much time and effort the taxpayer devotes to the activity and the taxpayer’s manner in conducting the activity. In cases involving real estate businesses, courts have also considered factors such as the quantity and the quality of the rented properties and the provision of significant services to the tenant. While many courts have disagreed over whether or not ownership of a single rented real property qualifies as a trade or business, the Tax Court at least has mostly favored the notion that one is enough given the right circumstances.8
Obviously, a very thorough analysis of the facts and circumstances is required to ascertain whether or not an investment in real estate rises to the level of a trade or business. An experienced tax professional is a valuable resource for this analysis. Meanwhile, taxpayers wanting to qualify their real estate business should:
(1) carefully track the time they devote to their real estate business-documenting everything from time spent paying bills to maintaining and improving the property, and
(2) understand that the likelihood of the IRS qualifying a real estate business generally increases with the number of units rented.
If you have questions about whether an investment in real estate qualifies as a real estate business entitled to the QBI deduction, call Frost & Associates, LLC today at 410-497-5947.
2IRC §199A(c)(1).For a more comprehensive discussion of QBI, please see our article,Section 199A: New 20% Pass-Through Deduction, at ________________.
6REG-107892-18, 83 Fed. Reg. 40884 (Aug. 16, 2018).Note that the proposed regulations would also extend the definition of trade or business beyond the IRC §162 definition by clarifying that “the rental or licensing of tangible or intangible property to a related trade or business is treated as a trade or business if the rental or licensing and the other trade or business are commonly controlled under proposed § 1.199A-4(b)(1)(i).”
7Commissioner v. Groetzinger, 480 U.S. 23 (1987).
8See, e.g. ,Fegan v. Commissioner, 71 T.C. 791, 814 (1979);Elek v. Commissioner, 30 T.C. 731 (1968);O’Madigan v. Commissioner, 19 T.C.M. 1178 (1960);Lagreide v. Commissioner, 23 T.C. 508 (1954),Hazard v. Commissioner, 7 T.C. 372 (1946).
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