For real estate owners, this distinction isn't just a technicality; it can materially impact the financial viability of an investment.
The Qualified Business Income (QBI) deduction under Section 199A has provided significant tax benefits to many real estate owners and investors. By allowing a deduction of up to 20% of qualified business income, it can effectively lower tax rates and boost after-tax returns.
However, not all rental real estate activities are eligible. A crucial first step is that the activity must qualify as a trade or business under Section 162. For real estate owners, this distinction isn't just a technicality; it can materially impact the financial viability of an investment.
Understanding the “trade or business” standard
Section 162 defines a trade or business as an activity conducted with continuity, regularity, and a profit motive. Determining whether a real estate enterprise meets this standard requires detailed, facts-and-circumstances analysis, which can make it tricky to apply.
Some common real estate activities often fail to meet this standard:
- Triple-net leased properties — Here, the tenant is responsible for nearly all expenses (taxes, insurance, and maintenance) leaving the owner with minimal operational involvement.
- Single-property arrangements — These are often characterized by minimal oversight or services provided by the owner.
In these situations, the rental income might not satisfy the Section 162 standard, which makes the valuable Section 199A deduction unavailable.
A tale of two investments: A family office perspective
Consider a family office evaluating two different real estate investments:
Investment 1: Single-tenant commercial property under a triple-net lease
- This is a long-term lease with a creditworthy tenant, offering a predictable income stream.
- The downside? It requires minimal involvement from the owner. Because of this lack of operational activity, this investment may not qualify as a trade or business under Section 162, making the QBI deduction a non-starter.
Investment 2: Multifamily residential property
- This property has multiple units and necessitates active property management.
- The owner has ongoing responsibilities, including tenant relations, leasing, maintenance, and capital planning. These activities are far more likely to constitute a trade or business, supporting eligibility for the QBI deduction on the net rental income.
While both investments might generate similar pre-tax cash flow, their after-tax returns could diverge dramatically depending on Section 199A eligibility. This highlights the importance of looking beyond just the gross returns.
The IRS’s safe harbor
To provide clearer guidance, the IRS introduced an optional safe harbor in Revenue Procedure 2019-38. If a rental real estate enterprise meets these specific requirements, it is automatically deemed to be a trade or business for Section 199A purposes.
To qualify for the safe harbor, a company must:
- Maintain separate books and records for each rental real estate enterprise
- Perform at least 250 hours of rental services during the tax year (or in three of the prior five years for an established enterprise). Services can be performed by owners, employees, agents, or contractors and include tasks like advertising, lease negotiations, and maintenance
- Keep contemporaneous records of all services performed, noting the hours, description, dates, and who provided the service
- Attach a signed statement to the tax return each year affirming reliance on the safe harbor
Exclusions to the safe harbor are important to note. Properties subject to triple-net leases and those used as a residence under Section 280A (such as vacation homes) are not eligible.
It's important to remember that this safe harbor is optional. A rental activity can still qualify under the general facts-and-circumstances test of Section 162 even if it doesn't meet these specific safe-harbor requirements.
Key tax takeaways for real estate investors
The operational intensity of your real estate business can significantly impact your after-tax returns. To help improve your tax position, real estate owners and family offices should:
- Scrutinize whether your activities rise to the level of a trade or business
- Group comparable properties to either meet the safe-harbor standards or strengthen your Section 162 position
- Keep detailed books, records, and logs to substantiate your qualification
- Compare projected after-tax returns with and without the QBI deduction to see its real impact
The bottom line for real estate investors is this: your eligibility for the Section 199A deduction depends not just on what properties you own, but critically, on how you operate them.
A single-tenant triple-net lease may be operationally simple, but it could fall short of the "trade or business" standard. In contrast, a multifamily property with active management is much more likely to qualify.
The IRS safe harbor provides an elective pathway to certainty, but careful analysis and robust documentation are essential regardless of the route you take.
How CLA can help with tax planning strategies
CLA helps real estate investors navigate the complexities of Section 199A by evaluating whether rental activities qualify as a trade or business. We guide clients through the IRS safe harbor rules, assist with grouping strategies, and support documentation efforts to strengthen eligibility.
Whether you're managing multifamily assets or triple-net leases, CLA provides the insight and tools to improve after-tax returns.