Maximizing Your Pass-Through Deduction
In 2018, a new income tax deduction went into effect under the Tax Cuts and Jobs Act.
It is called the pass-through deduction or, less commonly, the Qualified Business Income (QBI) deduction.
If you qualify (and most landlords do), you may be able to deduct up to 20% of your net rental income from your income taxes. This will reduce your effective income tax rate on said income by 20%.
This deduction should be around through 2025, unless Congress terminates it earlier.
Let’s break down how it works for residential landlords and what you can do to get the most out of it.
How Does the Pass-Through Deduction Work?
The pass-through deduction helps qualified individuals deduct up to 20% of their income through entities like limited liability corporations and partnerships. There are, of course, some limitations and rules around determining this deduction.
A pass-through business is a business that doesn’t pay taxes, but instead passes its income and tax liability to its owners.
It’s also worth noting that the pass-through deduction isn’t an itemized or above-the-line deduction. In other words, you don’t have to track every little detail to utilize it, and it doesn’t reduce your adjusted gross income like deducting student loan interest does.
How Do You Qualify?
Let’s pivot to how you qualify for this deduction. There are three qualifying factors, and you must meet all three.
1. You must have a for-profit business.
First, your rental activity can’t be an investment or a not-for-profit activity. It has to be a for-profit business. You can find the criteria for qualifying as a business in IRS Reg. 1.199A-1(b)(14).
For most landlords, this isn’t a problem. Even if you only own a single property, the IRS often looks at that as a business for tax purposes. Of course, there are certain exceptions. If you rent your property at below-market rates or spend minimal time managing it, you may run afoul of the IRS. Fortunately, the safe harbor rule clarifies this. We take a closer look at the safe harbor rule below.
Rental activity means consistently and regularly engaging in actions related to your business with the goal of earning a profit. Almost every landlord is trying to make a profit, so this shouldn’t be an issue. Consistency is key, though, because you need to show that you’re invested in the business.
2. You must have a pass-through business.
Second, you need to have a pass-through business to qualify. In other words, the profits and losses go through the business, and you, the owner, pay tax on the money on your individual tax return.
Just like qualification one, most landlords organically run a pass-through business.
3. You must have qualified business income.
Finally, you need qualified business income (QBI). QBI is the net profit your rental business pulls in throughout the year. You figure this out by subtracting your regular rental deductions from your total rental income. You will list this figure in the “Total rental real estate and royalty income (or loss)” line at the bottom of Schedule E.
QBI doesn’t include:
- Short-term or long-term capital gain or loss
- Dividend income
- Interest income
- Wages paid to S corporation shareholders
- Guaranteed payments to partners in partnerships or LLC members, or
- Business income earned
The Safe Harbor Rule
Sometimes issues can arise if you only own a couple of units or one property. The IRS created a special safe harbor rule to help clear up much of this confusion.
A “safe harbor” rule protects you from the IRS. The IRS created a safe harbor rule specifically related to the pass-through deduction. If you abide by the rule, they will consider your business qualified. There are three requirements you must meet:
- You must keep separate records detailing income and expenses for each rental enterprise you run.
- You must perform 250 hours of rental activity per year.
- You must keep records showing the services performed.
It’s important to note that if you live in the property for 14 days or more than 10% of the days that the property is rented per year, you will not qualify.
Many landlords have questions about the 250 hours of rental activity needed per year. For 2022, you have to perform all 250 hours within the year. From 2023 onward, you meet the requirement if you complete the necessary hours in three of five consecutive years ending with the current year. These activities include:
- Advertising the rental
- Discussing and signing leases
- Verifying tenant application information
- Collecting rent
- Day-to-day operations and maintenance
- Rental management
- Buying materials
- Managing employees and independent contractors
Not every activity must be performed specifically by you. Employees, agents, and independent contractors are a part of the equation. Even if you hire a property manager, the time they put in still counts toward the 250 hours. So, what doesn’t count?
- Finance or investing activities
- Securing property
- Studying and analyzing financial statements or reports
- Planning or developing long-term capital improvement for your property
- Traveling time to and from property
If you decide to use the safe harbor, you must send the following signed statement with your tax return:
“Under penalties of perjury, I (we) declare that I (we) have examined the statement, and, to the best of my (our) knowledge and belief, the statement contains all the relevant facts relating to the revenue procedure, and such facts are true, correct, and complete.”
Include this statement as a pdf if you submit it electronically.
What If You Don’t Qualify for the Safe Harbor?
Even if you cannot meet the 250-hour requirement, you can still qualify for the pass-through deduction. You simply have to qualify as a business under the normal rules mentioned earlier. The IRS or courts have never required the 250-hour yearly hours of rental activity for you to qualify as a business. It’s not explicitly clear how many hours under 250 you can be, though, so try to get as close as possible.
How to Get the Most out of the Pass-Through Deduction
There are multiple ways to maximize the return on the pass-through deduction.
Maximize Rental Income
Your pass-through deduction is limited to 20% of net rental income. Therefore, the greater your rental income, the higher your deduction will be. If you pay off some or all of the debt in your rental property, you will increase your net income from the property.
Beyond that, you can sidestep your annual depreciation deductions for the initial years you own the property by avoiding cost segregation, bonus depreciation, or Section 179 expensing. The reason for this is that you’re spreading your depreciation deductions out over a greater number of years.
Purchase New Rental Property
We know that the maximum pass-through deduction is 20% of your net rental income (also known as your QBI). However, if your 2021 taxable income is over $214,900 if you’re single, or $429,800 if you’re married filing jointly, then your deduction will be restricted to the greater of (1) 50% of W-2 wages you give to employees, or (2) 25% of W-2 wages plus 2.5% of the unadjusted basis of your rental property. If you don’t have employees, the limit is typically 2.5% of your unadjusted basis in the rental property. If this number is equivalent to or more than 20% of QBI, your deduction will still be 20%. However, if the amount is less than 20%, your deduction will be limited to $2,500.
If you find yourself in the “less than” situation, you can improve your deduction by purchasing new rental property. This enhances your unadjusted basis to be multiplied by 2.5%. Additionally, you could hire new employees to work for your business. Then you can count 25% of the W-2 wages you pay plus the 2.5% of unadjusted basis. Just make sure the hiring makes sense for reasons beyond simply improving your pass-through deduction.
Limit Taxable Income Under W-2/Property Thresholds
Keeping your taxable income for the year under the W-2/property phase-in figures listed above is another way to maximize the pass-through deduction. For instance, if you ensure your 2021 taxable income is below or equal to $164,000 (for filing single) or $329,800 (for filing married), you’ll get the total 20% of QBI deduction.
Conclusion
Understanding the pass-through deduction can save you money and maximize your tax return.
If you’re not sure you qualify for the pass-through deduction, talk to your tax preparer or other tax professional. They should be able to advise you on the best steps to take to qualify for this valuable deduction.
