More than 30 years ago, the tax law was changed to come down hard on passive investors by limiting the losses they could claim under the passive activity loss (PAL) rules. The Tax Cuts and Jobs Act (TCJA) did not make a distinction between active and passive investors when it comes to the qualified business income (QBI) deduction. But there is a different problem for real estate investors to resolve.
The 20 percent deduction
The QBI deduction allows a personal write-off of up to 20 percent of income from a U.S. trade or business conducted through a sole proprietorship, partnership, limited liability company, or S corporation. Clearly, those in the real estate business--developers, contractors, property managers, and real estate brokers--are in a trade or business. But things get murky for real estate investors. The deduction applies to owners, whether active or passive, as long as the real estate activity constitutes a trade or business. This is not always easy to determine.
The tax law doesn't have a clear definition of what constitutes a "trade or business." The meaning of the term is largely derived from cases over the years. The proposed regulations for the QBI deduction say that investors must show they operate a real estate business in order to get the deduction. This means that they personally, or other employees of their business, must regularly and continuously spend substantial time engaged in the real estate activity. Again, there's no bright line fixing the amount of time or type of activities that need to be put into real estate for investors to get the deduction. And a determination under the passive activity loss rules as being "a real estate professional" based on "material participation" is no guarantee that the real estate activity is a trade or business.
The determination of trade or business is based on various factors, including:
- The type of property involved, such as commercial real estate or residential rental property.
- The number of properties.
- The day-to-day involvement of the owner or his/her agent.
- The type of lease (net lease, where an investor's involvement is minimized, versus traditional lease).
The important point for real estate investors is to document the time spent in and activities performed on their properties. Sole proprietors and single-member LLCs can nail down the determination of being in business by filing Schedule C of Form 1040 rather than reporting rental income and expenses on Schedule E of Form 1040. Using Schedule C declares you're in business, but the cost of doing so is subjecting net earnings to self-employment tax (profits on Schedule E are exempt from self-employment tax). It is essential to work with a tax adviser to run the numbers and see whether this strategy makes sense.
The new tax law did not change the PAL rules. Thus, if an investor's expenses are greater than his or her income from rental real estate, the losses generally cannot be deducted currently unless the investor is a real-estate professional.
A business or merely a source of income?
The new tax law clearly had real estate investors in mind when it added the unadjusted basis immediately after acquisition (UBIA) of tangible property, including real property, to the formula for figuring the QBI deduction. But to get to the point of using this, you need to prove that the real estate activities are in fact a business and not merely property held for the production of income. Tax pros have suggested that the IRS adopt a clear test for purposes of the QBI deduction (e.g., treating all rental realty as a business), but whether this happens remains to be seen.