The qualified business income (QBI) deduction under Internal Revenue Code (IRC) Section 199A introduces challenges and benefits for owners of pass-through businesses. Although the deduction can provide a significant tax opportunity, navigating the many rules and limitations associated with it can be complicated and time consuming. Here, learn key applications and requirements when determining the QBI deduction for taxpayers who receive QBI from multiple sources, such as Schedule K-1s and rental properties.

What Is Section 199A?

Section 199A, originating under the 2017 tax reform, became effective at the beginning of 2018. It provides a deduction of up to 20% of the QBI passed through to taxpayers from partnerships, S corporations, trusts, and sole proprietorships.

If a taxpayer is able to fully utilize the QBI deduction and is paying tax at the highest marginal rate of 37%, he is essentially paying a 29.6% tax rate—80% of 37%—on his business income.

How Can the Section 199A Deduction Be Used?

There are several hurdles when determining if a taxpayer can fully utilize the deduction and how she can deduct.

Qualified trade or business. To qualify for the deduction, the taxpayer’s income must be from a qualified trade or business. Generally, a qualified trade or business must:

• Be considered a trade or business under Section 162
• Operate in the United States
• Not be a specified service trade or business (SSTB)

Specified service trade or business. Businesses that qualify as SSTBs aren’t eligible for the deduction. There are many considerations when determining which businesses fall under the SSTB definition. Generally, an SSTB is any business that performs services in the following fields:

• Investing and investment management, trading, or dealing in securities
• Healthcare
• Law
• Accounting
• Actuarial science
• Performing arts
• Athletics
• Finance and brokerage
• Any trade or business in which the principal asset is the reputation or skill of one or more of its employees.

If the business involves activities that may fall within any of these categories, Treasury Regulation Section 1.199A-5 provides further guidance to determine whether it is considered an SSTB.

Possible Limitations

If the taxpayer’s business is a qualifying trade or business and their income qualifies for the QBI deduction, they could still face deduction limitations based on the greater of the following:

• 50% of the W-2 wages paid with respect to the trade or business allocated to the taxpayer, or
• 25% of these W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of depreciable property used in the trade or business

This stipulation was likely implemented to verify the deduction was only taken by businesses with a sufficient number of employees or heavy property investments.

It can sometimes be unclear whether a taxpayer’s rental activities qualify as a trade or business under Section 162. Neither the code nor its corresponding regulations includes a definition of a trade or business. However, several court cases provide guidance to help determine whether an activity, including rental real estate, is considered a trade or business.  

In general, a trade or business “must be involved with continuity and regularity in the activity for the purpose of making income or profit,” according to Commissioner v. Groetzinger 59 AFTR 2d 87-532. These activities must be “regular, systematic, and continuous,” as stated is Alvary v. United States 302 F.2d 790 to establish a trade or business under Section 162.

Rental activities that did not qualify typically involved properties that required little attention by the taxpayer or its agents, such as land, single-family homes, or triple-net-lease rentals. These rentals must receive substantial maintenance or be grouped with a large enough portfolio of properties to argue that, as a whole, they require regular and continuous management and other services.

Rental Real Estate Safe Harbor

Acknowledging this uncertainty, the IRS provided a safe harbor to help taxpayers verify their rental real estate activities qualify as trades or businesses for Section 199A.

Qualifying criteria. Revenue Procedure 2019-38 allows taxpayers to treat either a single rental property or an appropriate group of properties—called a rental real estate enterprise—as a trade or business if it satisfies the following for the tax year:

• Separate records are maintained that reflect income and expenses, which can include consolidating records from multiple properties.
• 250 or more hours of rental services are performed.
• Contemporaneous records are maintained on hours of services performed, including descriptions, dates, and involved parties.

Revenue Procedure 2019-38 details which rental services to include and omit. It also states that residential and commercial properties can’t be grouped into the same enterprise. Triple-net-lease properties don’t qualify for this safe harbor election.

Required documentation. Each year, taxpayers must attach a statement to their tax return, asserting they rely on the safe harbor. The statement must provide the following for each rental real estate enterprise:

• A description of all the enterprise’s rental real estate properties, including the address and rental category for each property
• A description of rental real estate properties acquired and disposed of during the taxable year, including the address and rental category for each property
• A representation that revenue procedure requirements have been satisfied.

Revenue Procedure 2019-38 also states that if an enterprise fails to satisfy the safe harbor requirements, it may still be treated as a trade or business if it can otherwise qualify under Section 162.

A taxpayer isn’t required to use the safe harbor for rental real estate, but it can provide certainty if there’s doubt whether rental activities reach the level of a trade or business. It also shows how the IRS views a rental activity when it’s considered a trade or business, whether or not the safe harbor is elected.

Initially, each trade or business passed through to the taxpayer is separately considered when applying the W-2 and UBIA limitations. Example. A taxpayer receives a Schedule K-1 from Partnership A, reporting $1,000 of QBI and $100 of W-2 wages with zero UBIA. The taxpayer receives another Schedule K-1 from Partnership B, reporting QBI of $200 and $500 of W-2 wages with zero UBIA.

Due to the wage limitation, the taxpayer can only take a QBI deduction of $50 from Partnership A, even though 20% of its QBI is $200. The taxpayer’s QBI deduction from Partnership B is $40—or 20% of $200—far below its wage limitation of $250.

If the taxpayer is able to aggregate Section 199A attributes between the two partnerships, it would have $1,200 of QBI with $600 of W-2 wages, resulting in an allowable QBI deduction of $240 instead of $90.

1. The same person or group of persons owns 50% or more of each trade or business directly or by attribution under Sections 267(b) or 707(b).
2. This ownership exists for the majority of the taxable year.
3. The trades or businesses report on the same taxable year.
4. None of the trades or businesses is an SSTB.

 If this test is met, trades or businesses must then satisfy at least two of the following:

1. Provide products, property, or services that are the same or customarily offered together
2. Share facilities or significant centralized business elements, such as personnel, accounting, legal manufacturing, purchasing, human resources, or IT
3. Operate in coordination with, or reliance upon, one or more of the businesses in the aggregated group—for example, supply chain interdependencies

 This aggregation can be made at the individual or entity level. That means a partnership holding multiple rental properties can elect to aggregate them as a single trade or business and combine and report the Section 199A information accordingly to the partners.

This approach can dramatically simplify partners’ and partnerships’ Section 199A reporting because they are reporting only a single trade or business. In many cases, it can increase the allowable QBI deduction passed through to the partners because it allows the wage and UBIA limitations to be pooled together.

It’s important to note that, regardless of aggregation or wage and UBIA limitations, QBI losses will offset QBI income from other trades or businesses. Therefore, the impact of a loss from a trade or business to the overall QBI deduction should be the same whether or not an aggregation is made.

• Name
• Business description
• Employer Identification Number
• Dates when trades or businesses are added to, or disposed to, the aggregated group during the tax year

• Trade or business requirements. An activity must be a trade or business prior to aggregation. That means properties such as single-family homes or land rentals may not qualify, unless they’ve otherwise been grouped with a trade or business.
• Independent grouping. Aggregating under Section 199A is independent from elections to aggregate or group activities under other code sections, such as Sections 469 or 465.
• Residential and commercial limitations. Commercial and residential properties aren’t considered similar property that can be aggregated under Section 199A. The regulations don’t address if different types of commercial properties, such as retail versus office, can be aggregated, but these aggregations should be made with caution.
• Aggregation permanence. Once properties are aggregated, they stay aggregated unless facts and circumstances change that make the activities ineligible for aggregation, so confirm that aggregation is beneficial before committing to it.

Aggregation should be seriously considered when a taxpayer is reporting Section 199A information from multiple trades or businesses. Depending on the taxpayer’s situation, it could dramatically increase their allowable QBI deduction and simplify reporting.

If a taxpayer has qualifying Section 199A income from multiple businesses that have common ownership, are centrally managed, and are either similar or interdependent businesses, aggregation could likely help them increase their QBI deduction.

Section 199A certainly comes with benefits and burdens. Depending on a taxpayer’s situation, there could be a variety of ways to determine the deduction—especially when rental real estate is involved.

The rental real estate safe harbor and aggregation elections can provide opportunities to increase this deduction, but it’s important to be familiar with the qualifications and requirements to verify these are opportunities you can and should apply.

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