If you own rental property, classifying it as a trade or business rather than an investment can have a significant impact on your tax bill. The distinction is especially significant in light of the 20% Section 199A deduction available as a tax break for rental real estate to certain sole proprietors and pass-through entity owners.
The 199A deduction is available for qualified business income (QBI), which can be generated by an eligible trade or business but not by an investment. Assuming you meet the other requirements, qualifying your rental real estate activities as a trade or business may result in significant tax savings. Fortunately, a safe harbor is established by an IRS Revenue Procedure.
The biggest tax break for rental real estate
The 199A deduction is far too complicated to go into detail here. But in general, it allows owners of sole proprietorships and pass-through entities — partnerships, S corporations, and, in general, limited liability companies (LLCs) — to deduct up to 20% of their net business income without having to itemize.
Eligible owners are entitled to the full deduction as long as their taxable income does not exceed an inflation-adjusted threshold ($164,900 for singles and heads of households; $329,800 for joint filers for tax year 2021). Above the threshold, the deduction may be reduced or eliminated for businesses that provide specific services or do not have enough W-2 wages or depreciable property.
Advice on renting out your property
According to the IRS, an enterprise is a trade or business for the purposes of the 199A deduction if it qualifies under Internal Revenue Code Section 162. That section does not define “trade or business” explicitly; it is determined on a case-by-case basis based on a variety of factors. In general, a trade or business is an activity that is carried out “on a regular, continuous, and substantial basis” with the goal of profit.
Uncertainty about whether rental real estate qualifies prompted the IRS to issue Revenue Procedure 2019-38 to establish a safe harbor. A rental real estate enterprise (RREE) is deemed a trade or business under the Revenue Procedure if the taxpayer (you or a “relevant pass-through entity” in which you own an interest):
- Maintains separate books and records for the enterprise,
- Performs at least 250 hours of rental services per year (for an enterprise at least four years old, this requirement is satisfied if you meet the 250-hour test in at least three of the last five years),
- Keeps logs, time reports or other contemporaneous records detailing the services performed, and
- Files a statement with his or her tax return.
The Revenue Procedure specifies the types of services that count toward the 250-hour minimum and specifies whether they can be performed by the owner, employees, or contractors. It also defines an RREE as one or more rental properties owned directly by the taxpayer or through disregarded entities (for example, a single-member LLC).
In general, taxpayers must either treat each rental property as a separate enterprise or treat all similar properties as a single enterprise. Commercial and residential properties, for example, cannot be combined in the same enterprise.
Opportunities for Planning
There may be opportunities to restructure rental activities in order to fully benefit from the safe harbor and other tax breaks for rental real estate. Mary, for example, owns a rental residential building and a rental commercial building and provides 125 hours of rental services per year for each property. As previously stated, she is unable to combine the properties into a single enterprise, so she fails the 250-hour test.
But suppose she trades the residential building for another commercial building for which she provides 125 hours of service. Then she can treat the two commercial buildings as a single entity and qualify for the safe harbor (provided the other requirements are met).
Are you a real estate professional?
Ordinarily, taxpayers who “materially participate” in a trade or business are entitled to deduct losses from wages or other ordinary income and avoid net investment income tax on business income. To assess material participation, the IRS employs a number of tests. For example, you materially participate in an activity if you devote more than 500 hours per year, or if you devote more than 100 hours and no one else does.
Rental real estate, on the other hand, is generally regarded as a passive activity — that is, one in which you do not materially participate — regardless of how much time you spend on it. There is an exception for “real estate professionals.”
To qualify for the exception, you must spend at least 750 hours per year — and more than half of your total working hours — on real estate businesses (such as development, construction, leasing, brokerage, or management) in which you materially participate. (Working hours as an employee do not count unless you own at least 5% of the company.)
Don’t try this at home.
The tax treatment of rental real estate is complicated. Consult with one of our tax advisors if you want to take advantage of the 199A deduction or other tax breaks for rental real estate.