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ContinueThe pass-through deduction allows qualifying real estate investors to deduct up to 20% of net business earnings from their income taxes.
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.
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.
A safe harbor is a legal or regulatory provision with specific conditions or criteria that if you meet allow individuals or entities to receive legal protection, tax relief, or other benefits. Safe harbors are generally established to provide clarity and predictability, often in complex or ambiguous areas of law or regulation.
In the context of the 20% pass-through deduction safe harbor refers to a set of conditions that, if satisfied, would make an individual or qualifying business eligible for a 20% pass-through deduction on taxable rental income. We take a closer look at these conditions as well as what a qualifying business entity and qualifying business income are below.
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:
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:
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 comprise activities such as advertising for rental, negotiating and executing leases, reviewing tenant applications, rent collection, daily operational and maintenance tasks, real estate management, procurement of materials, and oversight of both employees and independent contractors. All services conducted by owners, employees, agents, or contractors contribute to the cumulative 250 hours requirement.
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 tracker 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.
You must have a pass-through business to qualify for this deduction. A "pass-through business" is any business that is owned and operated through a pass-through business entity, which includes any business that is:
For tax purposes, what distinguishes these types of businesses is that they pay no taxes themselves. Instead, the profits (or losses) from such businesses are passed through the business, and the owners pay tax on the money on their individual tax returns at their individual tax rates.
The vast majority of smaller businesses are pass-through entities. Indeed, over 86% of businesses without employees are sole proprietorships.
Regular "C" corporations don't qualify for this deduction. However, they do qualify for a low 21% corporate tax rate on all their income. Unlike the pass-through deduction, the 21% rate for C corporations is permanent under the TCJA.
Related: How to Structure Your Real Estate Business: Sole Proprietorship, Partnership, LLC, or S-Corporation?
Individuals who earn income through pass-through businesses may qualify to deduct from their income tax an amount equal to up to 20% of their "qualified business income" (QBI) from each pass-through business they own. (IRC Sec. 199A).
QBI is the net income (profit) your pass-through business earns during the year. You determine this by subtracting all your regular business deductions from your total business income. QBI includes rental income so long as your rental activity qualifies as a business (as most do). It also includes income from publicly traded partnerships, real estate investment trusts (REITs), and qualified cooperatives.
QBI doesn't include:
QBI is determined separately for each separate business you own. If you own multiple businesses that are not service businesses listed below, you have the option of combining them into one for the deduction, but only if at least two of the following requirements are satisfied:
If one or more of your separate businesses lose money, you deduct the loss from the QBI of your profitable businesses. If you have a qualified business loss—that is, your net QBI is zero or less—you get no pass-through deduction for the year. Any loss is carried forward to the next year and is deducted against your QBI for that year.
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.
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 like Quickbooks for property management. This makes Landlord Studio an ideal solution for rental property management and accounting that will help you make the most meeting conditions required for every available deduction.
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.
Landlord Studio is an easy to use property management and accounting software designed for landlords.
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