To provide clarity on the effect of tax reform on the real estate industry, we will be focusing on a different aspect of the newly passed legislation every month. Keep in mind that there still are many open questions as to how these new provisions will apply to taxpayers.
The first topic in our series is the 20% deduction for qualified business income of pass-thru entities (20% deduction). The significance of the 20% deduction is that it levels the income tax playing field between pass-thru entities such as S corporations, Partnerships, Sole Proprietors, etc., with the newly reduced C corporation flat tax rate of 21%.
In general, pass-thru business owners could receive a deduction from taxable income of up to 20% of their business income. In other words, if your pass-thru business income is $100k, you may receive a reduction from taxable income of up to $20k. Yes, we are hedging a bit. As with most tax laws, some thresholds and limitations come into play when calculating the 20% deduction.
Keep in mind, the calculation of the deduction and applicable limitations will occur at the individual owner level. Typically, an individual’s share of pass-thru income and related items used in the calculation, as described below, is based on their ownership interest in the entity. The following discussion will break down the rules of this deduction into its fundamental components: Qualified Business Income, thresholds, and limitations.
Qualified Business Income (QBI) – At its most basic level, QBI is the net operating income of the business. Typically, your share of QBI is the business net operating income multiplied by your ownership percentage. Wages and guaranteed payments reported on your individual tax return, even those paid to you by your business, are not permitted to be included for purposes of calculating QBI.
Please note that QBI does not include capital gains and other types of investment income. For real estate professionals, this exclusion of capital gain income from QBI is of great importance as the sale of real estate may result in capital gain. Consequently, if you have an operating loss, but capital gain income, you will not have the ability to generate a 20% deduction on that capital gain income.
Thresholds – Generally, for taxpayers with income of less than $315,000 (Married Filing Joint) or $157,500 (all other taxpayers), the first set of limitations discussed below will not apply. Your deduction will be 20% of QBI. If you exceed the thresholds described above, your 20% deduction could be reduced based on the limitations mentioned below.
Limitations – The first step in determining your deduction is to multiply your QBI by 20%. The next step in the calculation may result in a limitation to your 20% deduction. Please keep in mind that, as discussed above, this limitation only applies to taxpayers with income over $315,000 (MFJ).
For purposes of calculating the limitation, your 20% deduction will be limited by the greater of your share of the following items from the entity generating the QBI:
- 50% W-2 Wages paid by the business or;
- 25% of W-2 Wages paid by the business, plus 2.5% of the allocable share of the original cost of fixed assets used in the company.
It is part two of this limitation that may be of particular interest to owners of commercial and residential rental properties as a related management company typically pays the wages rather than the entity holding the rental activity itself. For purposes of part two, the original cost of fixed assets includes those assets subject to depreciation such as buildings, related improvements, equipment, etc. Land, unfortunately, is not a qualifying asset for purposes of this calculation.
Further, the cost is original cost, not the net value after depreciation. Asset cost will be includable in this second part for the greater of the depreciable life of the property or 10 years. For example, the second prong of the test could include the original cost of a commercial building for 39 years (or 40 years in some cases).
Finally, there is an overall limitation of the owner’s taxable income that will impact the amount of the 20% deduction. After the maximum deduction is calculated based on the two steps described above, the actual deduction is equal to the lesser of the combined 20% deductions or 20% of the sum of taxable income (based on your tax return) less net capital gain. Thus, inhibiting the use of the 20% deduction on types of income other than QBI (i.e., capital gain). See an example of this calculation below.
Keep in mind that there are still a lot of unknowns in this area. The provisions of tax reform will continue to evolve as guidance comes out from the IRS. We will keep you updated as that information is released. Look for the next article in our series – Impact of changes to depreciation. Contact Jennifer Wesselman or Scott Cress at 513.241.8313 or online for more information.