By Eric Seidman, CPA
Whether it is a result of the proliferation of do-it-yourself television programs or uncertainty surrounding the stock market, many people have been consistently turning to rental real estate as an alternative investment vehicle. While owning rental real estate can help diversify a portfolio and provide additional cash flow, there are numerous considerations for how the activity is reported and how it interacts with other items on a tax return. With the Tax Cuts and Jobs Act (TCJA) that went into effect for the 2018 tax year, there are even more factors to consider when preparing a personal income tax return.
Generally, residential rental activity is considered to be passive. In a typical setup, the owner rents the house but does not perform substantive services. Sure, the owner may help out with repairs and keep the books, but that generally does not reach the level of active. If the rental reports a loss, the loss is also deemed passive, and on Form 1040 passive losses can only offset passive income. A loss on one rental property can offset income on another, but the net loss of all properties, if passive, cannot reduce active income from other sources (such as W-2 wages or K-1 pass-through from active trades).
A lessor could qualify as an active renter if certain criteria are met and income is below an applicable threshold ($75,000 for single filers, $150,000 for married joint filers). If a lessor qualified as an active renter, he or she could deduct up to $25,000 of a passive loss beyond offsetting passive income.
If a lessor qualified as a real estate professional, which has a stringent set of rules, all real estate activity is considered active, and losses are effectively unlimited. This is difficult to qualify for; among numerous other criteria, a substantial number of hours must be spent on real estate activities, and no other activity can really be occupied. For example, a full-time doctor would have difficulty trying to pass herself off as a real estate professional. The criteria is qualitative and quantitative.
So, how is all of this affected under the new tax law?
The TCJA introduced the concept of qualified business income (QBI), which allows business owners to deduct 20 percent of their business income with a number of rules and limitations. If a taxpayer has rental activity generating $30,000 of income, he or she would seemingly qualify for a $6,000 QBI deduction (20 percent of the $30,000 total). However, if this taxpayer is married filing jointly, and total income exceeded $415,000, suddenly the QBI deduction is no longer automatic. At that point, the QBI deduction would need to be supported by either 50 percent of W-2 wages paid by the business or 25 percent of wages plus 2.5 percent of the unadjusted gross fixed asset basis.
For rental real estate ventures, wages are unlikely to be paid; the unadjusted gross fixed asset basis will be derived from the house and any other improvements (excluding land). In the example above, consider the following additional facts:
- Joint income = $420,000
- Rental property original cost = $104,000
- Capitalized improvements = $8,000
- Rental net income = $30,000
In this example, income is subject to the aforementioned limitations, and since no wages are paid the limitation is based on 2.5 percent of the gross unadjusted fixed assets. In this case, 2.5 percent of $112,000 is $2,800. The QBI deduction on the full $30,000 is $6,000, but this is limited to $2,800 as a result of the income limitations and thresholds.
Before considering what the QBI deduction looks like, rental real estate holders have to consider if their activity even qualifies, on a qualitative basis, as a trade or business subject to QBI standards. Joe Taxpayer who works as a CPA and owns one investment property will have a hard time justifying that he has a real estate trade or business. Sure, he wants to turn a profit, but the property is an investment and not a business. If he owned 20 different rental units and spent significant time operating those leases, the case may be more favorable, but it isn’t a slam dunk.
Case in point: while learning that a QBI deduction is available for small-business owners, including those who rent real estate, taxpayers will need to consult their tax advisers to determine if they qualify for the deduction, and just how much that deduction may be. The QBI deduction does not always apply, and it is crucial to discuss the passive/active ramifications with a tax adviser as well.
Renting out real estate is a popular investment alternative for many, regardless of personal wealth. However, determining how the activity is reported on an income tax return and what new policies may apply, can get very complicated, very quickly. When considering purchasing a property for rental activities, it is best to discuss the situation with a tax adviser ahead of time to get everything situated at the forefront of the venture. Just as one would stage a house to attract a tenant, one should properly map out how it might all impact the income tax return before making an important investment decision.
Eric Seidman, CPA, is a manager at Wouch, Maloney & Co. LLP in Horsham, Pa. He is a member of PICPA’s Image Enhancement Committee and Greater Philadelphia Chapter Federal Taxation Committee.