Eight months into the tax year, practitioners and taxpayers anticipated that the Section 199A deduction rules, released recently by the Internal Revenue Service ("IRS"), would provide clarity—especially for rental property owners. Unfortunately, this hasn’t been the case. Many questions are still unanswered. Based on the existing information, our tax advisors identified opportunities where you, as a rental property owner, can take advantage of the Section 199A deduction rules.
The Deduction: a Debriefing
Details affecting tax planning are constantly unfolding, but at present, for tax years 2018 to 2025 the deduction can be up to 20% of a pass-through entity owner’s qualified business income (“QBI”). The House recently passed a bill eliminating the 2025 expiration date. We will monitor this closely to determine how you should re-strategize your planning if the Senate affirms the House’s bill.
It is important to note that the QBI deduction is available only to individuals, estates and trusts. Restrictions may apply at higher income levels or may be based on the owner’s taxable income.
The proposed regulations adopt the Internal Revenue Code Section 162 definition of a trade or business. The case law generally requires continuous and regular activity in order to qualify. While relatively modest amounts of activity have been accepted by some court, as evidence of a trade or business, holding triple net lease property is a form of activity that is problematic. Due to the complexity of these proposed regulations, the IRS supplies operational rules to help you identify your deductible QBI. The “phaseout rule” is also explained.
Phaseout is calculated based on taxable income before any QBI deduction. The phaseout threshold begins at $157,500 ($315,000 for married joint filers), and phaseout is complete when an owner’s taxable income reaches $207,500 ($415,000 for married joint filers). At that point:
- QBI deductions for a non-specified service business must be based on the business’s W-2 wages or its W-2 wages plus the basis of qualified property used in the business; and,
- No QBI deduction can be claimed based on income from a specified service trade or business.
The $157,500 threshold presents an interesting planning opportunity.
Step to Take
As a rental property owner, you may want to consider dividing ownership of your properties among multiple trusts so that each would have taxable income below the $157,500 threshold. This will maximize the utility of the pass-through deduction , making more income eligible for the deduction, without the need to satisfy the deduction limitations, discussed below. There are anti-abuse provisions in the proposed regulations which make proper planning necessary. This strategy, if effective, will also enable the deduction of additional state and local taxes since each trust gets its own $10,000 cap. Finally, it may also fit well with updated estate and gift planning strategies and provide asset protection.
Deduction limitations exist; however, none – with the exception of those that apply to taxable income – apply to dividend income from REITs. You may want to consider creating private REITs to house rental real estate that might not rise to the level of a trade or business if held by some other pass-through entity.
The deduction can’t exceed 20% of QBI, and it can’t exceed 20% of the individual’s taxable income calculated before:
- Any QBI deduction; and,
Any net capital gain amount (net long-term capital gains in excess of net short-term capital losses plus qualified dividends).
The deduction is further limited to:
- 50% of the W-2 wages attributable to the business; or,
- 25% of the wages plus 2.5% of the Unadjusted Basis at Initial Acquisition (“UBIA”) of the depreciable property used in the business.
A business’s UBIA generally equals the original cost of the property. Qualified property is defined as depreciable tangible property, including real estate, that:
- Is owned by a qualified business as of the tax year end;
- Is used by the business at any point during the tax year for the production of QBI; and,
- Hasn’t reached the end of its depreciable period as of the tax year end.
In defining UBIA, the regulations exclude basis step-ups on transfers of partnership interests. Additionally, for property received in a Section 1031 exchange, UBIA includes only the remaining basis of the relinquished property plus any additional funds invested in the replacement property.
Benefits of Aggregating your Business
When an individual owns interests in several qualifying non-specified service trades or businesses, (“SSTB”)the individual can choose to aggregate and treat them as a single business. If you have higher taxable income, aggregating businesses can allow you to claim a larger QBI deduction when the limitations based on W-2 wages and the UBIA of qualified property would otherwise reduce or eliminate the allowable deduction. For instance, if a high-income individual owns an interest in one business with high QBI but little or no W-2 wages and an interest in another business with minimal QBI but significant W-2 wages, aggregating the two could result in a healthy QBI deduction. Keeping them separate could result in a lower deduction or maybe no deduction at all. However, certain tests set forth in the proposed regulations must be passed for businesses to be aggregated. Also, it’s important to remember that an SSTB cannot be aggregated with any other business, including another SSTB.
Interestingly, none of these limitations – other than the one based on taxable income – apply to dividend income from REITs. This leads to the observation that you may want to create private REITs to house rental real estate, which may not rise to the level of a trade or business if held by some other pass-through entity.
Our experienced tax professionals will keep you informed as more information regarding the new section 199A deduction rules continue to unfold. Contact your Friedman advisor to address any questions you have.