Does Income from a Triple Net Lease Qualify for the Qualified Business Income Deduction?June 4, 2021
By Maya Khan, CPA
The Qualified Business Income (QBI) deduction introduced by the Tax Cuts and Jobs Act of 2017 provides a significant tax incentive for owners of pass-through entities. The QBI deduction is available to many owners of partnerships, S corporations and sole proprietorships, enabling them to deduct up to 20% off their share of profits from a trade or business. Since rental income profits from commercial or residential real estate are considered a trade or business, they qualify for the 20% deduction.
But what about property that is rented on the basis of a triple net lease? Many real estate professionals have multiple types of properties, some they actively maintain and others as triple net lease investments. With a triple net lease, the tenant assumes responsibility for paying real estate taxes, building insurance and costs to maintain the property. Triple net leases have become popular investment choices for individuals looking for a steady stream of income while assuming minimal risk. In addition, many triple net leases provide long-term investment stability for the landlord.
When it comes to the QBI deduction, however, landlords who hold triple net leases are not considered to be engaged in a trade or business as explained in the law, accompanying regulations and IRS guidance. Therefore, the profits from these leases do not qualify for the 20% QBI deduction. In addition, since the rental properties involved may be considered passive investment vehicles to some, the profits could be subject to the 3.8% net investment income tax.
As an alternative to a triple net lease, landlords who want to minimize taxes need to assume responsibilities for their properties’ expenses. When a lease is about to expire (or if the lease can be adjusted before expiration), we recommend renegotiating with the tenant. First, the landlord must assume responsibility for paying the building property tax and/or other expenses such as insurance and maintenance. These expenses do not need to be absorbed by the landlord, but rather charged back to the tenant through escalations. In addition, the landlord should work with an attorney to rewrite the lease and remove any "triple net lease" wording. Having confidence in a tenant is an important factor in determining if the lease can be renegotiated. A landlord would want to assure the basic rent and escalations are paid timely. By doing these small (yet cost beneficial) modifications, the owner of the property may be able to deduct up to 20% of their share of the profits on their individual tax returns.
As an example, Partnership A owns a commercial rental property with a triple net lease that brings in basic rental income of $300,000 per year. Since the tenant is responsible for the costs of the property, there are limited deductions on the partnership tax return and net profit is reported on Schedule K. A 50% owner of this partnership would report $150,000 of rental real estate income on their personal tax return and could be subject to income and net investment income taxes on the $150,000 since they do not qualify for the 20% QBI deduction.
Now, say the landlord can renegotiate the lease with the tenant and retain the basic rental income of $300,000 per year. In addition, the landlord will pay the real estate taxes and insurance of $50,000 and charge these expenses back to the tenant as escalations. The net profit would remain the same and the 50% owner would continue to report $150,000 of net rental real estate income on their personal return. However, now that the commercial property is no longer considered to be a triple net leased property, the owner will be able to enjoy the 20% QBI deduction of $30,000 and pay income tax on the net of $120,000.
The language of Code Section 199A, which governs the QBI deduction, states that the income must be derived from operation of a trade or business. To meet that standard, the landlord’s involvement must be continuous and regular and the primary purpose of the activity must be for income or profit. By renegotiating a lease, paying some of the property expenses and charging back to the tenant, the landlord’s involvement may now rise to the level of a 199A trade or business, thus meeting the standard to offer the 20% QBI deduction.
Under current law, the QBI deduction is scheduled to expire on December 31, 2025. President Biden has suggested the deduction would be phased out for taxpayers earning more than $400,000 but it was not addressed in the latest Build Back Better recovery plan. Since the future is unknown, landlords who hold triple net leases have an immediate opportunity to renegotiate with tenants and minimize taxes on their properties.