What is the Pass-Through Deduction in Real Estate?

Taking advantage of deductions in real estate can lead to significant tax savings. The money that you are saving on taxes can then be reinvested back into your portfolio, allowing you to grow it further.

Depreciation, repairs, and mileage are all examples of deductions that we’ve covered before. In this article, we take a look at the pass-through deduction and what this means for real estate investors and landlords.

What is the pass-through deduction in real estate?

The pass-through deduction, which is more formally known as the Section 199A Qualified Business Income (QBI) deduction, went into effect in 2018 (off the back of the Tax Cuts and Jobs Act). It is currently set to last until the end of the 2025 tax year and allows for a 20% deduction on rental income for qualifying real estate investors and landlords. It is optional and not automatically available to all investors, as there are certain criteria that need to be met.

How do you qualify for the pass-through deduction?

Owning and managing a rental property is not an automatic gateway to the pass-through deduction, nor is being qualified as a real estate professional (REP). For one landlord, managing a single rental property may make them eligible for the deduction, but another landlord who is a REP and also only has one rental property may not meet the requirements. Instead, it is dependent on other factors.

In order to qualify for the 20% pass-through deduction on rental income, the rental real estate must meet one of the following criteria:

1. Classified as a trade or business according to Section 162
2. The real estate is a self-rental, which is when a taxpayer rents property they own to his or her own business.,
3. Meets the requirements of the safe harbor

Regarding the safe harbor, this is a provision to sidestep or eliminate legal liability provided that certain conditions are met. This rule for landlords states that the following requirements must be met:

• More than 250 hours of rental services are performed each year
• Separate books and records are kept for each rental
• Maintain a log of time and hours spent engaged in rental activity

During or after 2023, the 250-hour requirement will be met as long as the hours have occurred in any three out of five consecutive years (ending with the current year).

Rental services include:

• Advertising
• Negotiating
• Processing tenant applications
• Collecting rent
• Daily operations, maintenance, and repairs
• Management
• Purchasing materials
• Supervision of employees and/or contractors

Rental services exclude:

• Financial management
• Investment management
• Studying financial statements or reports
• Planning
• Travel hours

Rental activities do not necessarily need to be carried out by the landlord to benefit from the deduction. Hours can be made up by employees or independent contractors. The important thing is that everything is accurately recorded. Dates, descriptions of the service, and names of people who performed services should be noted.

One way to easily track the hours spent managing your rentals is to keep a detailed log. To this effect, you can use the inbuilt mileage log in Landlord Studio as a time tracker and simply run a mileage report at the end of the year to tally up your total hours.

What kind of properties are not eligible for the pass-through deduction?

Even if you are a landlord who spends over 250 hours of a year performing rental services, you may not be eligible for the pass-through deduction depending on other factors. If you own rental real estate that you also occupy, the 20% deduction is not applicable. Likewise, property rented on a triple net lease basis is excluded from the deduction.

Managing your rental property

Given that you are only eligible for the pass-through deduction if you maintain a watertight log of all rental activity that is carried out, it is imperative that you have a good management system in place. Utilizing purpose-built property management software like Landlord Studio will allow you to manage and maintain your rental property portfolio while processing tenant applications and collecting rent. Being safe in the knowledge that your portfolio is easily manageable will reduce stress, helping you to comply with IRS regulations.

Landlord Studio will also enable you to separate your bookkeeping by property, rather than lumping properties together, as is often the case when using general accounting software. This makes it an ideal solution for rental property accounting that will help you make the most meeting conditions required for any available deductions.

Final words

To reap the benefits of the pass-through deduction, it is not enough to simply manage a portfolio that produces a property. You need to actively participate and show proof of doing so. Utilizing the right software will enable you to take full advantage of the 20% deduction, allowing you to grow your portfolio to its fullest potential.

Find out more about how Landlord Studio can help you manage your rentals and make the most of the tax advantages of being a real estate investor →

‍