The Tax Cuts and Jobs Act (TCJA) created a brand new tax deduction for pass-through businesses. This pass-through deduction for property managers can benefit both you, as the owner of property management business, and your owner clients.
And it can be worth a lot. In fact, if you qualify, you may be able to deduct up to 20% of your business income from your income taxes. The pass-through deduction went into effect in 2018 and is set to last through 2025.
However, there are some questions about when smaller landlords are entitled to it. Fortunately, property managers can take measures to help their property owner clients qualify. Let’s get into how.
For a summary of the TCJA, check out: How does the new tax law impact property managers? 9 changes to be aware of.
What Makes Property Managers Eligible for the 20% Pass-through Deduction?
If you’re the owner (or co-owner) of a profitable property management business, you’re likely entitled to claim the pass-through deduction on your upcoming income tax return. Here’s what you need to be able to qualify for it.
#1: You Must Have a Pass-through Business
What is a pass-through business, you ask? First, in order to be considered an eligible pass-through entity, your property management business must be structured as one of the following:
- Sole proprietorship (a one-owner business where the owner personally owns all the business assets)
- S corporation (S corp)
- Limited liability company (LLC)
- Limited liability partnership (LLP)
The good news is that the vast majority of property management businesses are pass-through entities. Still, there are a couple of deal breakers for the IRS. You don’t qualify for the pass-through deduction if you’ve formed a regular C corporation. Additionally, employees do not qualify for the pass-through deduction. So, if you’re an employee in a property management business you can forget about taking it.
What about having your employer reclassify you as an independent contractor? It won’t work. IRS regulations make it clear that employees can’t get the deduction simply by having their employers reclassify them as independent contractors. The regulations provide that if a worker is reclassified as an employee—but continues to perform the same work directly or indirectly for the hiring firm that he or she did when an employee—the IRS will presume that worker doesn’t qualify for the pass-through deduction for the next three years.
Pass-through business owners providing certain types of services and who have 2019 taxable income above $160,700 ($321,400 if married) are not entitled to claim the pass-through deduction. This includes lawyers, accountants, consultants, investment managers, financial planners, and stock brokers. However, this restriction does not apply to property managers or real estate brokers.
#2: You Must Have Qualified Business Income
You qualify for the pass-through deduction only if you have qualified business income (QBI). QBI is the net income (profit) your property management business earns during the year. QBI does not include:
- Short-term or long-term capital gain or loss—for example, the capital gain (or loss) earned from selling your property
- Dividend income or interest income
- Guaranteed payments to partners in partnerships or LLC members
- Business income earned outside of the United States
If you have a qualified business loss—that is, your 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 specific year.
#3: You Must Have Taxable Income
To determine your pass-through deduction, you must first figure your total taxable income for the year (not counting the pass-through deduction). This is your total taxable income from all sources (business and investment income) minus deductions, including the standard deduction ($12,200 for singles and $24,400 for marrieds filing jointly in 2019) or your itemized deductions. Pro tip: don’t include net capital gains for the year in your taxable income (such amounts already receive preferential tax treatment). If you’re married and file jointly, include your spouse’s income in your taxable income.
How Much Is the Pass-through Deduction Worth?
The amount of the pass-through deduction depends on your annual taxable income.
Taxable Income Up to $160,700 ($321,400 if Married): If your 2019 taxable income is at or below $160,700 if single, or $321,400 if married filing jointly, your pass-through deduction is equal to 20% of your qualified business income (QBI). However, the deduction may not exceed 20% of your taxable income.
For example, if your QBI is $100,000, you’re entitled to a $20,000 pass-through deduction, provided your taxable income is at least $100,000.
Taxable Income Above $210,700 ($421,400 if Married): If your taxable income is above $210,700 (single) or $421,400 (married filing jointly), your maximum possible pass-through deduction is 20% of your QBI, just like at the lower income levels. However, when your income is this high, a W-2 wage/business property limitation takes effect. Your deduction is limited to the greater of:
- 1. 50% of your pro rata share of W-2 employee wages paid by your business, or
- 2. 25% of W-2 wages PLUS 2.5% of the acquisition cost of the depreciable property used in your business.
For example, if you own a property management business and have $500,000 in taxable income, you’ll be subject to these limitations. Let’s say you have two employees who you pay a total of $100,000 in W-2 wages. You also own business property with a depreciable basis of $100,000. Your pass-through deduction is limited to the greater of (1) 50% of W-2 wages, or (2) 25% of W-2 wages plus 2.5% of your property’s $100,000 basis. (1) is $50,000 (50% x $100,000) (2) is $5,000 (2.5% x $100,000) + (25% x $100,000) = $27,500. Your pass-through deduction is $50,000.
Taxable Income $160,701 to $210,700 ($321,401 to $421,400 if Married): If your 2019 taxable income is $160,701 to $210,700 (single) or $321,401 to $421,400 (married filing jointly), the W-2 wages/property limitation described above is phased in—that is, only part of your deduction is subject to the limit and the rest is based on 20% of your QBI.
The Pass-through Deduction for Landlords
Landlords can also qualify for the pass-through deduction. The rules are the same for them as for any other pass-through business.
Pass-through Deduction Amounts for Landlords
For lower-income landlords, the pass-through deduction is equal to 20% of the profit they earn from their rental properties and business. For example, a landlord with taxable income under $160,701 ($321,401 if married) who earns a $10,000 profit from a rental activity is entitled to a 20% pass-through deduction, or $2,000.
Higher income landlords (taxable income over $210,700 ($421,400 if married)) are fully subject to the W-2 wage/business property limitation discussed above. Since most landlords don’t have employees, their deduction is limited to 2.5% of the acquisition cost of the depreciable property used in the rental business, including the real property rented to residents. The cost is its unadjusted basis—the original acquisition cost, minus the cost of land.
Example: Hal and Wanda are married and file jointly. Their taxable income for 2019 is $500,000, including $25,000 in QBI they earned from their rental business. They have no employees. They own a duplex they bought four years ago for $250,000. The land is worth $50,000, so its unadjusted acquisition basis is $200,000. Since their taxable income was over $421,400, their pass-through deduction is limited to the greater of (1) 50% of W-2 wages, or (2) 25% of W-2 wages plus 2.5% of their duplex’s $200,000 basis. (1) is 0 (2) is $5,000 (2.5% x $200,000) + (25% x 0) = $5,000. Their pass-through deduction is $5,000.
Rental Activity Must Be a Business (199a)
However, to qualify for the pass-through deduction, a landlord’s rental activity must be a business for tax purposes—not an investment activity. This is defined under the general rules used to determine whether any activity is a business. (IRC Section 162; IRS Reg. 1.199A-1(b)(14).)
So, what’s a business? Rest assured this isn’t a philosophical question. The general rule is that any activity (including a rental activity) qualifies as a business if you engage in it to earn a profit and work at it regularly and continuously. Applying this rather vague test is a highly factual determination. The IRS says that relevant factors that can be considered include, but are not limited to the:
- Type of rented property (commercial versus residential property)
- Number of properties rented
- Owner’s or the owner’s agents day-to-day involvement
- Types and significance of any ancillary services provided under the lease
- Terms of the lease (for example, a short-term lease versus long-term lease)
- Status of whether or not the landlord has filed all required information returns (Form 1099-MISC).
Landlords with many rental units should have little trouble qualifying as a business. But what about small landlords or those with only one or two rental units? Neither the IRS nor courts have ever conclusively said whether such landlords are in business. However, both have said that ownership of even one rental unit can be a business, depending on the circumstances.
Because this is a legal grey area, the IRS could claim that a landlord with only one or two units is engaged in an investment activity, not a business, and is not entitled to the pass-through deduction.
IRS Safe Harbor Rule
To assure landlords with absolute certainty, the IRS has created a safe-harbor rule. Landlords who satisfy the rule are automatically deemed to be in business solely for purposes of the pass-through deduction. Use of the safe harbor is purely optional. A landlord who fails to qualify to use the safe harbor can still qualify as a business—there is just no guarantee.
Under the Safe Harbor Rule, landlords are automatically deemed to be in business solely for purposes of the pass-through deduction if they:
- Perform a total of 250 hours of real estate rental services each year (including work performed by employees and agents)
- Keep records documenting the real estate services performed
- Maintain separate books and records showing income and expenses for each rental real estate enterprise. (IRS Rev. Proc. 2019-38.)
The 250-hour requirement applies year-by-year from 2018 through 2022. For 2023 or later, you satisfy the requirement if 250 or more hours of services are performed in any three of five consecutive years ending with the current year.
Real estate rental services include the following:
- Advertising to rent the real estate
- Negotiating and signing leases
- Verifying information in tenant applications
- Collecting rent
- Daily operation, maintenance, and repair of the property
- Managing of the real estate
- Purchasing of materials
- Supervising employees and independent contractors.
Here’s the most important things property managers should understand about this safe harbor: These rental real estate services don’t all have to be performed by the landlord personally. They may also be performed by a landlord’s employees, agents, or independent contractors. If a landlord hires a real estate management company, the time it spends managing the property counts toward the 250-hour requirement.
Pro tip: If you don’t do so already, you should keep track of the time you and your employees spend performing rental management services for your clients, especially for small landlords with only one or a few units. If you perform 250 or more hours any year, the client can take advantage of the Safe Harbor Rule and does not have to worry about the IRS challenging his or her pass-through deduction on the grounds that the rental activity is not a business. You can list yours in your monthly billings or provide an annual statement. Also, be sure to provide a general description of the services performed. This can be a valuable service for smaller landlords who are worried about qualifying for the pass-through deduction!
Don’t Forget Your 1099s
The IRS says that one important factor it will look at when determining whether rental activity is a business or investment is whether the landlord files all required 1099-MISC forms. All landlords should make sure to make these filings.
You need to file a 1099-MISC whenever you pay an unincorporated independent contractor $600 or more in a year for work done on a rental property owner’s behalf. However, there is an important exception to the 1099-MISC filing requirements for payments made electronically or by credit card. Read the Buildium 2019 Tax Guide for Property Managers for more information and, as always, consult your accountant and check for updated guidance from the IRS on the pass-through deduction.
Pass-through deductions can boost property management businesses’ profitability (and their owner clients) this tax year and for the foreseeable future. But it takes more than knowing the rules to get the most out of this deduction. As with most things related to accounting in property management, consistency, education, and process will get you and your owners across the finish line. You want a value add during tax time for your owners? Don’t miss this one.Read more on Accounting & Taxes