As a landlord, you have a variety of responsibilities come tax season.
Rental property taxes are some of the most complex they are, and fully understanding them is not easy. It’s important that you do, because otherwise you will miss out on some of the best deductions available for property owners.
One tax concept all landlords should know is Qualified Business Income (QBI). This type of revenue is significant because if you can prove that you have it, you can qualify for one of the best tax deductions: the pass-through, or QBI, deduction.
However, before you can apply this deduction, you need to understand what QBI is and how to know whether you have it.
Let’s break down what Qualified Business Income is and how it helps you with the pass-through deduction.
Qualified Business Income: Definition
So what is qualified business income? According to the IRS, QBI is the net profit your rental business generates each year. It includes income from partnerships, S corporations, sole proprietorships, and certain other trusts.
QBI is calculated by subtracting your total expenses or rental deductions from your total revenue generated.
There are a few important kinds of income that doesn’t qualify as QBI. If you receive the following types of income, you cannot include them in your QBI total (view a complete list on the IRS’s site):
- Wage income
- Investment items like capital gains, losses, or dividends
- Interest income
- Income unconnected with business within the U.S.
- Foreign currency gains or losses
- Wages paid to S corporation shareholders
- Guaranteed payments to your partner or LLC members
So why is QBI relevant to landlords during tax season? QBI is the income used in one of the most valuable deductions for rental property owners, the qualified business income deduction. We will discuss this deduction in detail later.
What is a Pass-Through Business?
Another concept you must understand before diving into the QBI or pass-through deduction is the concept of a pass-through business.
Pass-through businesses are businesses that do not pay taxes directly but pass their income and tax responsibilities to their individual owners. If you own a pass-through business, you pay tax on your rental income as you would on your wages or other income—on your individual tax return.
Most small and mid-sized landlords run a pass-through business organically.
The Pass-Through Deduction
Now we’re ready to discuss the pass-through deduction. This deduction is a lucrative opportunity for landlords looking to save money on their taxes.
Also called the qualified business income deduction (QBID) or Section 199A, the pass-through deduction allows landlords to deduct up to 20% of their rental income from their income taxes plus 20% of REIT dividends and PTP income. This deduction is done through entities such as limited liability corporations (LLCs) and partnerships.
To qualify for this deduction, you must meet three criteria:
- You must be a for-profit business. This criterium concerns the three landlord classifications: passive investor, business-owner, and not-for-profit owner. To qualify for the pass-through deduction, your business must be for-profit. You can prove that your business meets this requirement by demonstrating your active and regular engagement in rental activities and/or by making a profit.
- You must be a pass-through business. As mentioned above, you need a pass-through business to qualify for this deduction. Like the for-profit requirement, this criterium usually doesn’t pose a problem for most landlords.
- You must have qualified business income. You need QBI to take this deduction.
Occasionally, the above criteria can be difficult or confusing to apply. For this reason, the IRS has established a safe harbor, or exception, to the above criteria. If you
- Keep separate records for income/expenses for each rental enterprise,
- Complete 250 hours of rental activity per year, and
- Keep records showing services performed
you automatically qualify for the pass-through deduction. If you can’t meet the safe harbor criteria—no problem. You can apply the original three criteria to use the pass-through deduction.
One thing to note: If you yourself live in your property for 14 days or greater than 10% of the days your property is rented, you do not qualify.
By taking the time to research and understand the pass-through deduction, you are setting yourself up for success come tax season. QBI and the pass-through deduction is just one of many ways you can save money and maximize your tax return next year.