The Tax Cuts and Jobs Act (TCJA), the massive tax reform law enacted by Congress in 2017, took full effect in 2018. The TCJA established a brand new income tax deduction for owners of pass-through businesses, which includes most landlords.
If you qualify, you may be able to deduct up to 20% of your net rental income from your income taxes. This deduction began in 2018 and is scheduled to last through 2025.
Landlords have been among the biggest winners under the TCJA.
For landlords, the most stunningly good provision of the TCJA was a new tax deduction for owners of pass-through businesses. This includes the vast majority of residential landlords who own their rental property as sole proprietors (who individually own their properties), limited liability companies (LLCs), and partnerships. With these entities, any profit earned from the rental activity is "passed through" to the owner or owners' individual tax returns, and they pay tax on it at their individual income tax rates.
Example. Alex, a single person, owns a duplex she rents out. She earns a total profit of $20,000. Alex is a sole proprietor. She reports her rental income and expenses on IRS Schedule E. She adds her $20,000 rental profit to her other income and pays tax on it at her individual tax rates. Her top tax rate is 24%, so she pays $4,800 in income tax on her rental profit.
The TCJA created a new tax deduction for individuals who earn income through pass-through entities. (IRC Sec. 199A.) If your rental activity qualifies as a business for tax purposes, as most do, you might be eligible to deduct an amount equal to 20% of your net rental income.
This deduction is in addition to all your other rental-related deductions. If you qualify for this deduction, you'll effectively be taxed on only 80% of your rental income.
You qualify for an income tax deduction equal to 20% of your rental income if:
Example. Assume that Alex from the above example had $100,000 in taxable income in 2023. Because she was a sole proprietor, she may take a pass-through income deduction of 20% x $20,000 rental income = $4,000. As a result, she saves $960 in income tax.
This deduction is subject to some limitations if your income exceeds the limits above.
This deduction is a personal deduction you can take on your return whether or not you itemize. But it isn't an "above the line" deduction that reduces your adjusted gross income (AGI).
If your 2023 annual taxable income is over $232,100 if you're single or $464,200 if you're married filing jointly, you are still entitled to a pass-through deduction of up to 20% of your rental activity income. However, your deduction can't exceed:
Because most residential landlords have no employees, the 25% plus 2.5% deduction will be of most benefit to them.
Example. Assume that Alex, from the above examples, earned $250,000 in total taxable income during 2023. She has no employees in her rental business. So, her pass-through deduction is limited to 2.5% of the purchase price of the long-term property she uses in her rental activity. This consists of her duplex, which she purchased five years ago. Her depreciable basis in the duplex (purchase price minus value of the land) is $100,000. Her pass-through deduction is limited to 2.5% x $100,000 = $2,500.
The 2.5% deduction can be taken during the entire depreciation period for the property, which is 27.5 years for residential property. But it can be no shorter than 10 years.
Unfortunately, this deduction can be complex. To qualify for the deduction, you must:
There is one more requirement that could prove a stumbling block for some smaller landlords: To claim the pass-through deduction, your rental activity must constitute a business for tax purposes, not an investment activity.
Surprisingly, neither the IRS nor courts have ever provided any detailed rules on when a rental activity is a business. Now, the IRS has provided some additional guidance and a special safe harbor rule that can help many landlords.
Not every activity that earns money is a business for tax purposes. For any activity to be a business, you must engage in it regularly and continuously, primarily to earn a profit. A "sporadic" activity doesn't qualify.
Virtually all landlords are trying to make a profit. However, by itself this isn't enough for a rental activity to be a business. You must work at it regularly and continuously.
How much time must you put in for your rental activity to be a business? This amount has never been clearly defined by the IRS or courts. It is clear, however, that you don't have to work full-time at it. Moreover, you don't have to do all the work yourself. You can hire a manager or others to help you and still qualify as a business.
Landlords who own many rental units are almost certainly in business. However, questions can arise where a landlord owns only a few units or only a single rental unit. For this reason, many tax professionals have been uncertain whether small landlords can claim the pass-through deduction. To help alleviate the uncertainty, the IRS has created a special safe harbor rule.
A "safe harbor" rule keeps taxpayers safe from the IRS. If you follow the rule, the IRS won't bother you. The IRS is enacting a safe harbor rule for landlords solely for purposes of the pass-through deduction. If you follow the rule, the IRS will assume your rental activity is a business for purposes of the pass-through deduction—but for no other purpose.
You must satisfy three requirements to use the safe harbor:
If you have more than one residential rental property, you can combine them together for purposes of these requirements. However, you can't combine residential with commercial properties.
You can't use this safe harbor if you live in the property more than 14 days during the year or more than 10% of the number the days during the year the property is rented.
Real estate rented or leased under a triple net lease is also not eligible for this safe harbor. Triple net leases require the tenant to pay for maintenance and insurance as well as rent. They are seldom used for residential real estate.
The 250-hour rental services requirement applies year-by-year for 2018 through 2022. For 2023 and 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:
Such services don't all have to be performed by you, the property owner. They may also be performed by your employees, agents, or independent contractors. For example, if you hire a real estate management company, the time they spend managing your property counts toward the 250-hour requirement.
The following types of activities do not count toward the 250 hours:
Starting in 2019, you must maintain contemporaneous time reports, logs, or other records, showing:
You don't need to file these records with your tax return. Keep them available for inspection at the IRS's request.
Because rental services performed by managers, agents, employees, and independent contractors count toward the 250-hour requirement, you should ask such workers to keep track of the time they work on your rentals.
This records requirement doesn't apply for the 2018 tax year because the safe harbor wasn't created by the IRS until 2019.
The rental pass-through deduction safe harbor is purely optional. You don't have to use it if you don't want to. Moreover, failure to satisfy its requirements doesn't mean your rental activity isn't a business. For example, you don't have to assume your rentals are not a business if you spend only 200 hours performing rental services during the year.
The safe harbor was created as a matter of convenience and to help tax professionals process the complex pass-through deduction. It doesn't establish absolute rules for how much work you must do for your rental activity to constitute a business for purposes of the deduction.
Whether any rental activity is a business is determined on a case-by-case basis based on the particular facts involved. Both the IRS and courts have found that ownership of even one rental property can constitute a business for tax purposes. However, the IRS and courts have also said that renting a single property (or more) doesn't always constitute a business—it all depends on the facts and circumstances, including the day-to-day involvement of the owner or its agent.
Find out about IRS audit rates and the odds of being audited in What Are the Triggers of IRS Tax Audits?
Learn how much time most people spend doing business taxes.
Get information about common tax deductions for individuals.
For more information on this and other tax issues affecting landlords, refer to Nolo's Every Landlord's Tax Deduction Guide, by Stephen Fishman (Nolo).
If you need more help, talk to a tax professional, such as a certified public accountant or a tax attorney. A tax professional can prepare tax returns or provide tax information, guidance, or representation before the IRS.