This is our fifth installment of our monthly tax blog about the Tax Cuts and Jobs Act. This blog will revisit a topic discussed in our third installment, however this blog post will focus on how the Qualified Business Deduction affects specifically rental properties.
General Overview of Qualified Business Income Deduction
The Qualified Business Income Deduction allows for a 20% deduction against Qualified Business Income (“QBI”). The deduction is available to qualifying trade or business owners of partnerships and S Corporations, as well as those who are sole proprietorships which report income on Schedule C or Schedule E. The deduction will take effect for tax years beginning after December 31, 2017, and is scheduled to sunset on December 31, 2025.
If a business qualifies for this deduction, the owner would only pay tax on 80% of his or her income from the qualifying trade or business rather than 100% (subject to various limitations). As you can see, this can provide some major tax savings for businesses owners.
Definition of a Qualified Trade or Business
In order for a trade or business to qualify for the new deduction it must be a qualified trade or business. A qualified business refers to any trade or business except for:
- Services performed by employees:
For example, if you receive wages for working as a professor at a university, you cannot take a Section 199A deduction on those wages.
- “Specified service” businesses. This includes businesses in the fields of health, law, accounting, consulting, brokerage or financial services, performing arts, and athletics.
For example, if you own a partnership interest in a law firm, you generally cannot take the deduction on your pass-through income from the firm. However, if your income from a “specified service” business is below the high income threshold covered in the limitations section below, this exclusion does not apply.
Definition of Qualified Business Income
Qualified Business Income (QBI) includes all of the income, deduction, gain, and loss items that are connected to operating a trade or business. Investment-related income items such as capital gains and losses, dividends, and interest are excluded from QBI.
When calculating the deduction, a taxpayer can only include their allocable share of QBI. For example, if a taxpayer owns 40% of an S Corporation for the entire tax year; they would include 40% of the S Corp’s qualified income in their QBI.
Limitations on Deduction Amount
There are two ways that a taxpayer’s initial 20% deduction can be limited to a lower amount. The first limitation applies only to higher income taxpayers, and the second limitation applies to all taxpayers.
Higher Income Taxpayers
For single taxpayers with income above $157,500 or married filing joint taxpayers with income above $315,000, the deduction is limited to the greater of:
- 50% of W-2 wages paid by the trade or business, or
- 25% of W-2 wages paid by the trade or business, plus 2.5% of the unadjusted basis of the business’s depreciable property.
Regardless of income level, all taxpayers must limit their deduction to 20% of taxable income less their net capital gains. This limitation was included in the legislation to ensure that taxpayers do not take the deduction on income that is already taxed at the preferential capital gains rates.
How Does this Apply to Rental Owners?
The Good News for Rental Owners
The good news is that if a rental qualifies for the new deduction the owner could get up to a 20% deduction against income, which will help reduce their taxes. For example, if a rental owner has a rental which qualifies for the new deduction and generates net taxable income of $20,000, the owner could possibly have an additional deduction of up to $4,000 = $20,000 * 20% (subject to limitations). The $4,000 deduction could save the taxpayer up to $1,480 in taxes ($4,000 * (37% federal tax rate), assuming they fall into the 37% tax bracket.
The Not So Good News for Rental Owners
The not-so-good news is the question as to whether a rental qualifies / raises to the level of a qualified trade or business for the new deduction.
In the past, the IRS has taken the position that not all rentals rise to the level of a trade or business. This has required the courts to get involved with disputes between taxpayers and the IRS. When determining whether a rental rises to the level of a trade or business, the courts have based their decisions on various factual elements, including the type of property (commercial real property versus a residential condominium versus personal property), the number of properties rented, the day-to-day involvement of the owner or its agent, and the type of rental (for example, a net lease versus a traditional lease, short-term versus long-term lease).
Due to this uncertainty, we, as tax professionals, have been waiting for additional guidance from the IRS around this issue. In early August of 2018, the IRS provided additional guidance for the Qualified Business Income Deduction, however, unfortunately the IRS didn’t provide the detailed additional guidance we were looking for around whether rentals qualify for the new deduction.
What Does This Mean for Me?
The next question that may come to mind is either, “How does this uncertainty apply to me?” or “What can I do ensure my rental qualifies for the new deduction?”.
Unfortunately, there is no clear cut answer as to how to ensure that your rental qualifies for the new deduction. However, there is some guidance that can be used from the various court cases to help strengthen the case that your rental is a trade or business.
First, make sure you are actively involved in your rental on a regular basis. The courts have widely accepted that being actively involved on a regular basis in your business is a hallmark of a trade or business.
This means that if you own one rental and have hired a property management company to manage your rental, then most likely you will not meet this test and may not qualify for the new deduction.
Second, look at the type of property that you are renting and how many rentals you have. Owners of multiple rentals that require a lot of hands on management will more likely qualify as a trade or business. However, rental owners who have a rental with a triple net lease to long-term tenants might now qualify for the new deduction.
Third, treat your rental like a business. This can be done by filing Form 1099s when required, setting up a separate bank account for each rental or rentals, using an accounting software to track the rental income and expenses, and track how much time you spend on the rentals, etc.
In conclusion, the IRS and the courts have stated that the determination of whether a rental raises to the level of a trade or business is one of facts and circumstances. Therefore, there is no one-size fits all answer.
At this time we are still waiting for additional guidance from the IRS around whether or not rentals qualified for the new deduction. However, steps can be taken to strength one’s case that his or her rental should qualify for the new Qualified Business Income Deduction.
This article is only a summary of the Qualified Business Income Deduction. There are other issues / topics such as “Self-Rentals”, rentals to a specified service businesses, etc. which were not discussed in this blog. If you have questions around these additional topics or have any questions regarding how this new deduction affects you, we recommend that you talk to your tax advisor or contact Eric Bell at firstname.lastname@example.org 541-342-5161.