What Real Estate Businesses, Investors Need to Know about the New Pass-Through Business Deduction by Laurence Bernstein, CPA
Posted on October 23, 2018
The vast majority of businesses in the U.S. are structured as pass-through entities, such as partnerships, S corporations and sole proprietorships. These entities pass their profits, losses and other attributes to their owners or partners each year, when tax is calculated at the individual’s tax return level. Although these businesses will not receive the benefit of a historically low 21 percent corporate tax rate introduced by the Tax Cuts and Jobs Act (TCJA), they may qualify for a new deduction of up to 20 percent of certain U.S.-source qualified business income (QBI). But first, taxpayers must take the time to understand the deduction and how it applies to their unique circumstances even without final regulations and guidance from the IRS. Following is what we know as of today.
What is the QBI Deduction?
The IRS defines QBI as the net amount of income, gains, deductions, and losses effectively connected with a taxpayer’s qualified U.S.-source trade or business and/or trusts and estates. Included in the QBI calculation are qualified dividends received from real estate investment trusts (REITs), qualified cooperative dividends, qualified income from publicly traded partnerships (PTPs), and income generated from rental property or from trusts and estates with interests in qualifying entities. Specifically excluded is income that is not effectively connected with a U.S.-source trade or business, investment income, interest income, and capital gains and losses.
After computing QBI at the entity level, separately for each of a taxpayer’s trades or businesses, eligible business owners/partners will calculate and apply any potential deduction at their individual tax return level. Taxpayers eligible for the full 20 percent QBI deduction are subject to a top effective tax rate of 29.6 percent on their QBI.
For tax years 2018 through 2025, the maximum amount that a qualifying business owner, trust or estate may deduct from its QBI is the lesser of:
- 20 percent of QBI from each of the taxpayer’s trades or businesses plus 20 percent of the taxpayer’s qualified REIT dividends and PTP income; or
- 20 percent of the portion of the taxpayer’s taxable income that exceeds the taxpayer’s net capital gain.
What are the Income Limitations to the QBI Deduction?
Married taxpayers with annual taxable income (before the QBI deduction) below $315,000 (or $157,000 for single taxpayers) who earn business income through a pass-through entity and not through W-2 wages are the biggest winners, who may be entitled to the full 20 percent deduction.
Once taxpayers’ income passes these annual thresholds, the QBI deduction is subject to restrictions based upon the amount of wages paid to W-2 employees and the unadjusted tax basis of qualified property immediately after acquisition (UBIA). Specifically, taxpayers who surpass these income tests will have a QBI deduction limited to the lesser of (1) or (2):
- 20 percent of QBI, or
- the greater of:
- 50 percent of the entity’s W-2 wages; or
- 25 percent of W-2 wages plus 2.5 percent of the UBIA (or the original purchase price) of depreciable tangible property, including real estate, furniture, fixtures, and equipment, that the business owns and uses to generate qualifying business or trade income.
W-2 wages are limited to the compensation amount the trade or business pays and reports to its common law employees on Form W-2. For this purpose, the proposed regulations clarify that payments made by Professional Employer Organizations (PEOs) and similar entities on behalf of trades or businesses can qualify as W-2 wages, provided that the PEOs issue the W-2’s to persons considered common law employees by the trades or businesses.
Under these limitations, pass-through businesses that pay large sums of W-2 wages may be able to take a larger QBI deduction than businesses that pay less W-2 wages or have fewer W‑2 employees. Similarly, capital-intensive businesses may be in a better position to maximize their QBI deductions than entities without a significant amount of tangible assets. Yet, it is important to note that the QBI deduction calculated from qualified REIT dividends and PTP income is not subject to these limitations.
What about Limitations for Specified Service Businesses?
The TCJA introduced a new concept of specified service trades or businesses (SSTBs), which are entities that involve the delivery of services in fields that include, but are not limited to, health, law, accounting, brokerage services, financial services and consulting. Under the law, businesses that meet the definition of a SSTB and have taxable income above certain thresholds will be limited in their ability to receive the full 20 percent QBI deduction.
Businesses in the engineering and architectural fields should thank their representatives in Washington, D.C., for specifically excluding them from the SSTB limitation. Treasury recently clarified that real estate agents, brokers, and real estate property managers are also specifically excluded from the SSTB limitation.
How Can I Maximize Tax Savings from the QBI Deduction?
Taxpayers may reduce their exposure to QBI deduction limitations when they increase the number of their W-2 employees or purchase equipment they currently lease. In addition, high-income taxpayers may be able to receive a larger QBI deduction when they aggregate their ownership interests in multiple qualifying businesses and treat them as a single business for calculating QBI, W-2 wages, and UBIA of property. Outside of QBI, some taxpayers may benefit by changing their entity to a C Corporation, which is subject to a flat 21 percent tax rate beginning in 2018. These decisions are neither easy, nor should they be made without weighing other key factors beyond the tax implications.
Taxpayers should meet with experienced tax advisors who not only understand the nuances of the law but who also can apply and substantiate claims of tax benefits based on the language of the guidance while adhering to the law’s anti-abuse provisions.
About the Author: Laurence Bernstein, CPA, is an associate director of Tax Services with Berkowitz Pollack Brant, where he provides tax and consulting service to high-net-worth families, entrepreneurs and growth-oriented business owners. He can be reached at the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or via email at email@example.com.
Information contained in this article is subject to change based on further interpretation of the law and guidance issued by the Internal Revenue Service.