Distinctions and definitions matter in tax law. This applies to every possible tax deduction, including the 20% qualified business income (QBI) deduction. The QBI deduction is available for income from an eligible trade or business, but it isn’t available if that same property is classified as an investment. So, it’s worth considering whether your rental property meets the definition of a trade or business under IRS requirements.

Determining status

The QBI deduction is too complex to cover fully here. But, in general, it allows owners of sole proprietorships and pass-through entities (for example, partnerships, S corporations, LLCs) to deduct as much as 20% of their net business income, without the need to itemize.

Eligible owners are entitled to the full deduction so long as their taxable income doesn’t exceed an inflation-adjusted threshold (for tax year 2024, $191,950 for individuals; $389,900 for joint filers). Above the threshold, the deduction may be reduced or eliminated for businesses that perform certain services or lack sufficient W-2 wages or depreciable property.

Some other advantages of trade-or-business status include the ability to deduct losses against ordinary income and avoidance of the 3.8% net investment income tax (NIIT). However, special rules apply to rental real estate owners, who generally must qualify as “real estate professionals” to fully enjoy these benefits. 

Unraveling definitions

According to the IRS, for purposes of the QBI deduction, an enterprise is a trade or business if it qualifies as such under Internal Revenue Code Section 162. That section doesn’t expressly define “trade or business” — it’s determined on a case-by-case basis based on various factors. Generally, a trade or business is an activity conducted “on a regular, continuous and substantial basis” with the aim of earning a profit.

Uncertainty over whether rental real estate qualifies, especially for taxpayers with one or two properties, prompted the IRS to issue Revenue Procedure 2019-38 to establish a safe harbor. Under the Revenue Procedure, a rental real estate enterprise (RREE) is deemed a trade or business 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 that’s 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 lists the types of services that count toward the 250-hour minimum and clarifies that they may be performed by the owner or by employees or contractors. It also defines an RREE as one or more rental properties held directly by the taxpayer or through disregarded entities (for example, a single-member LLC). Generally, taxpayers must either treat each rental property as a separate enterprise or treat all similar properties as a single enterprise. (Commercial and residential properties can’t be combined in the same enterprise.)

Using the safe harbor

There may be opportunities to restructure rental activities to take full advantage of the safe harbor. For example, let’s say you own a rental residential building and a rental commercial building and perform 125 hours of rental services per year for each property. 

As noted, you wouldn’t be able to combine the properties in a single enterprise, so you wouldn’t pass the 250-hour test. But if you were to exchange the residential building for another commercial building for which you provide 125 hours of services, you could treat the buildings as a single enterprise and qualify for the safe harbor (provided the other requirements are met).

Be tax-savvy

Determining whether your rental real estate activities qualify for the QBI deduction is a complicated undertaking. To ensure that you make the correct distinctions, you’ll need to consult a tax professional.