Don’t miss out on the new tax law
that allows a deduction of up to
20% of business income.
Tax Day is around the corner and the full effects of the new 2017 Tax Cuts and Jobs Act will soon play out. If you are a real estate investor, there may be a lucrative upside to look forward to. New regulations in IRS Code Section 199A now allow a deduction of up to 20% of business income for pass-through businesses (i.e. sole proprietors, partners in partnerships, S corporation shareholders, and some real estate investors). If you make business income by renting, brokering or developing real estate, you could be in the money.
Wait . . .what? Twenty percent less taxes to pay? Yes, the Section 199A tax deduction is a very exciting new tax break for small businesses. It was designed so that small businesses would see a reduction in their taxes that approximated the big tax cuts that corporations are benefiting from in the Tax Cuts and Jobs Act. In the new law, Congress famously reduced the corporate tax rate from 35% to 21%. Most businesses in the United States, however, are not corporations; they are small businesses. The net profit of these businesses passes through to the owners on the owner’s individual tax return and is taxed at personal income tax rates, not corporate tax rates.
Before you crack the bubbly, however, you should be aware that the new regulations are riddled with exclusions, phase-outs, and uncertainties. So, things get complicated fast. Figuring out where your business stands—and whether you can organize your tax return to fit within the constraints of eligibility—will be the trick to determining how well you can benefit.
The simple rules about how the new Section 199A tax deduction works are this: It allows up to a 20% deduction on the net income earned from a qualified trade or business for tax payers with a total net income of less than $157,500 for single-filers, or $315,000 for a married couple filing jointly. The active leasing and brokering o f real estate can qualify. So, for example, if you make $100,000 renting and managing properties and you file as a single taxpayer, you could potentially get a deduction of $20,000 (20% of $100,000).
So, who can claim the deduction? The deduction is designed for taxpayers outside a corporation that are individual owners of sole proprietorships, partners in partnerships, and shareholders of S corporations. It also includes the rental income of real estate investors if your real estate investment activities rise to the level of a trade or business (more on this later). And you can take the deduction whether you itemize or not.
Importantly, the deduction is only for “qualified business income” earned in a “qualified business or trade,” and the income must be earned within the United States. If taxable income is comprised of both qualified business income and other sources of taxable income, such as capital gains, interest income, dividend income, or wages earned through a regular W-2 job, the deduction will be calculated only on the amount of the qualified business income. (Qualified real estate investment trust (REIT) dividends are not excluded.) Rental income must also account for depreciation.
Special Rules Apply
As this is tax code, naturally, there are several special rules to keep in mind. One is that the Section 199A deduction cannot exceed 20% of your total taxable income, or the total marital net income if you and your spouse file jointly, net of capital gains or losses. For example, if you earn $100,000 renting and managing properties and file as a married couple jointly, you use the $24,000 standard deduction and pay $16,000 into a solo 401(k), your total taxable income now equals $60,000. In this scenario, you are only eligible for a $12,000 deduction (20% of $60,000).
A second limitation is that taxpayers whose income is earned by way of a business that falls under the category of “specified service trade or business” face restrictions on getting the Section 199A tax deduction. This category targets professionals, such as doctors and lawyers, and businesses for which the principal asset is the reputation or skill of one or more of its employees, such as athletes and performers. But real estate professionals whose income is earned, in part, by providing consulting services to interested buyers or sellers of real estate may also face a reduced deduction. In this case, a de minimis test would be used to ascertain eligibility: If a business has gross receipts from consulting that amount to less than 10% of the combined receipts of all the activities of the business, then the consulting income will not be categorized as “specified service trade or business” income and, therefore, would be eligible for the deduction. (This threshold drops to 5% if the business has gross receipts of $25 million or more.)
For example: John is a real estate professional who owns a business brokering real estate and providing consulting services to people who want to buy real estate. If gross receipts from John’s consulting exceed 10% of the combined receipts of the whole business, then John will not be eligible for a deduction on the consulting portion of his income.
The Section 199A tax deduction is fairly straightforward if you have taxable income below $157,500 (single filers) and $315,000 (married couples filing jointly). If you are a real estate professional and your taxable income is less than the amounts above, you are eligible for the full 20% deduction on any qualified business income. This is true even when your business is considered a “specified service trade or business.”
Taxpayers who live in San Francisco, where average incomes are higher than the national average, however, may well fall victim to the deduction limitations that the IRS puts on taxpayers whom it deems to be high-income earners. When taxable income exceeds these thresholds written above, the tax deduction begins to erode—and things get complicated.
The qualified business income deduction of taxpayers who fall into this high-income category is limited based on 1) the type of business you operate, 2) whether your business pays W-2 wages, and 3) whether you have depreciable property. If taxpayers have taxable income above $157,500 and below $207,500 (for single filers) or above $315,000 and below $415,000 (for married couple filing jointly), these limitations are phased in. (Note: the threshold amounts and phase-in range are for tax-year 2018 and will be adjusted for inflation in subsequent years.)
When taxable income tops $207,500 for single filers or $415,000 for married couples filing jointly, you are no longer eligible for any Section 199A deduction unless you can beat the income limit with the wage or qualified property test.
Calculating Your Deduction
The first step in figuring out how much of a deduction you qualify for is to calculate how much your taxable income is. If you’re single and your income is below $157,500, or you’re married and filing jointly and your income is below $315,000, then your deduction will be the lesser of:
- 20% of your combined qualified business income (i.e. qualified business income plus 20% of any qualified real estate investment trust (REIT) dividends and any qualified publicly traded partnership income); or
- 20% of your taxable income minus net capital gains.
If your income is more than the high-income thresholds of $207,500 (single filers) or $415,000 (married filing jointly) the qualified business income deduction can’t exceed the greater of two amounts:
- 50% of the W-2 wages paid by your real estate business; or
- 25% of the W-2 wages paid by your real estate business plus 2.5% of the original cost of the depreciable assets used in the business.
If your taxable income falls within the “phase-in” range of $157,500 and $217,500 (single filers) or $315,00 and $415,000 (married filing jointly), the limitations above are phased in. In other words, your tax deduction will be reduced on a sliding scale. The details on this are notoriously complicated, so if you fall into this bucket, you should consult with a tax professional.
Are You Active Enough to Qualify?
Real estate professionals, such as independent real estate brokers, developers and contractors, who engage in the normal activities of those professions will usually qualify for the Section 199A tax deduction. Those who earn income by real estate rentals, however, must keep a few other considerations in mind.
First, the Section 199A deduction will be based on rental income net of operating expenses, interest deductions and depreciation deductions. Second, rental income will not be considered as qualified business income unless rental activity rises to the level of an “active trade or business.” Rental activity is generally considered a passive activity, so nailing down what this means is important for determining eligibility for the tax deduction.
According to the IRS, a taxpayer is engaged in an active trade or business if he is involved in an activity with “continuity and regularity,” of which the primary purpose is generating income or profit. If you are a landlord of a single property, or even several properties, that you rent on a long-term, triple net lease basis, do you qualify? Probably not. It doesn’t show enough activity to merely cash rental checks if you aren’t more actively managing the properties.
The final IRS regulations issued on January 18, 2019 provide limited guidance, but the IRS gives a safe harbor. The safe harbor applies if at least 250 hours are devoted to the rental activity by the property owner, employees or independent contractors in a year. Time spent on repairs, collecting rent, negotiating leases and providing tenant services counts. Hours put in for arranging financing, constructing long-term capital improvements, and driving to and from the real estate aren’t included in the 250-hour standard.
If the 250-hour test is met, you can treat the rental as a trade or business for purposes of the 20% pass-through deduction. Separate records and bank accounts must be maintained.
Taxpayer Be Wary
If you are involved in the real estate industry, it’s certainly a good idea to be familiar with the new Section 199A tax deduction opportunity. But the law is new and there are variables that could affect other parts of your tax return. The issues are very complicated—even for tax professionals. The proposed regulation guidelines that the IRS released last August provided some much-needed clarity on the subject, but the guidelines run almost 200 pages long—and they still left some questions poorly answered. And even if they don’t change, the law is set to expire in 2025 unless Congress renews it. In short, figuring out how to optimize your tax position for anything outside of simple situations means that you will soon be wading into the weeds of tax accounting.
So, if you think you might qualify for the Section 199A tax deduction you should certainly explore how you can restructure your taxes to take advantage of this favorable new deduction opportunity. But, it would be prudent to consider all the ramifications very seriously before making permanent changes—and to seek advice from a competent tax professional.
Elizabeth Shwiff, Partner is a partner at Shwiff, Levy & Polo, LLP. She is an expert in linguistics, speaks four languages, and holds multiple degrees, including a master’s degree in taxation. She has earned a stellar reputation for successfully representing clients as a formidable opponent to such entities as the IRS, the Franchise Tax Board, and the U.S. Department of Treasury. She’s a volunteer mediator and arbitrator in the Bar Association of San Francisco and the Community Boards of San Francisco.