Lisa Cai
Senior tax manager, ACM
The Tax Cuts and Jobs Act was signed into law in December 2017, in which most provisions would take effect in tax years beginning after Dec. 31, 2017. One of the most notable tax breaks introduced in the TCJA bill applicable to the 2018 tax year was the qualified business income deduction. With the 2018 tax year hurtling to a close, the need to understand the QBI deduction and how it will affect the real estate industry is surging. The new proposed regulations on Code Section 199A, Qualified Business Income, clarified many questions on how to calculate the deduction and how these new rules will impact the real estate industry.
What is Section 199A? First, we need to understand some of the basic mechanics behind the Code Section 199A. The idea behind the QBI deduction is seemingly simple and can be stated in one breath. However, the Internal Revenue Service proposed regulations providing guidance on the calculation of Section 199A is quite complex and requires a bit of unpacking.
Colloquially, the qualified business income deduction generally allows for a deduction of up to 20 percent of the QBI earned by a taxpayer (other than a C corp.). For example, if you earned $200,000 of QBI during the tax year, taxpayers eligible to claim the entire 20 percent QBI deduction could receive up to a $40,000 deduction.
Technically, under the U.S. code Section 199A, the QBI deduction generally allows for a deduction to qualified taxpayers equal to the lesser of the combined qualified business income or the amount equal to 20 percent of the excess, if any, of taxable income in excess of net capital gains for the tax year. This calculation applies only to taxpayers with taxable income below $315,000 for married couples filing jointly and $157,500 for all other taxpayers.
Defining key terms. Certainly, the most straightforward term to explain is a qualified taxpayer. A qualified taxpayer includes sole proprietorships, partnerships (including limited liability companies), S corporations, trusts and estates. One thing to keep in mind is that the QBI deduction will only apply to QBI earned by qualified taxpayers from domestic businesses.
The definition of combined qualified business income will add a few more critical terms to define. The combined qualified business income amount generally is equal to the sum of 20 percent of qualified business income from a qualified trade or business plus 20 percent of the aggregate amount of the qualified real estate investment trust dividends and qualified publicly traded partnership income for the taxable year.
Under the proposed regulations, the term qualified REIT dividends is any dividend a taxpayer received during the tax year that is not treated as capital gain and is not qualified dividend income. In other words, dividend income received from a REIT is qualified if it is income which would have been otherwise taxed at ordinary income tax rates.
Unfortunately for those who will be calculating qualified publicly traded partnership income, the definition is much more complex in comparison to qualified REIT dividends and therefore would require a more in-depth calculation. Luckily for investors, each PTP is required to determine its qualified PTP income for each trade or business and will report that information to its owners. Approaching the QBI deduction from a taxpayer’s perspective, the qualified PTP income definition is one the taxpayer can afford to glaze over.
Finally, qualified business income simply put is the taxable net income derived from a qualified trade or business. A qualified trade or business is any active trade or business except for specified services trade or businesses. SSTBs are any trade or business where the principal asset of the trade or business is the reputation or skill of one or more of its employees or owners. The SSTB limitation will not apply to those under the $315,000/$157,500 thresholds. For taxpayers with taxable income exceeding the $315,000/$157,500 thresholds, the QBI deduction calculation is adjusted for W-2 wages and the SSTB limitation will then apply. The Section 199A deduction and how it gets calculated for taxpayers above the taxable income threshold will be discussed in a follow-up article.
Are real estate trades or businesses qualified? Real estate agents, brokers or property managers, for example, are several service-based trades or businesses in which the principal asset is reliant on the skill of its employees or owners. Are these professions then considered SSTBs, which are consequently ineligible for the qualified business income calculation? Fortunately, Section 199A shows favor to the real estate industry in its definition of a “qualified trade or business.” Specifically carved out in the definitions and examples of the proposed regulations is that real estate agents, brokers or property managers are not considered SSTBs. These professions generally are considered a qualified trade or business for the purposes of calculating QBI.
The proposed IRS regulations for Section 199A also has adopted the more commonly used IRS Code Section 162 to define what constitutes as a “trade or business.” A trade or business as defined in Section 162 is an activity carried out for the purposes of making a profit and should be engaged in on a regular, ongoing and continuous basis. Sporadic activities are not considered to be a trade or business. For example, in the case of a landlord who makes substantial efforts to rent the property, provide maintenance or repairs, provide services to the tenants, or even hiring an agent to provide some of these services, etc., most likely would qualify as a trade or business. However, the trade or business determination is not outlined by any definitive test or threshold. The proposed regulations for Section 199A have illustrated some situations where rentals or licensing of a property would not meet the definition of a trade or business. Real estate professionals should evaluate each individual situation by its own set of facts and circumstances to substantiate the activity as a trade or business for the purposes of the QBI calculation.
