One of the most significant consequences of the Tax Cuts and Jobs Act of 2017 (TCJA) for taxpayers is the new Internal Revenue Code (IRC) section 199A, which allows a tax deduction for qualified business income (QBI). This provision provides unique opportunities and challenges to individuals engaged in certain real estate activities. Given the tax treatment afforded to investors in qualified real estate investment trusts (REIT) and publicly traded partnerships (PTP), the new IRC section 199A is significantly more advantageous to real estate professionals than those engaged in other trades or businesses. Consequently, the application of the provision to specific real estate transactions is uncertain. While the proposed regulations issued on August 8, 2018, address concerns about the new statute, certain material questions are left unanswered. Despite minimal guidance, there are still many tax-saving opportunities available to savvy taxpayers. This article summarizes tax strategies that individuals can utilize in order to maximize their tax deductions.
IRC section 199A allows noncorpo-rate taxpayers (individuals, estates, and nongrantor trusts) to deduct 20% of the income earned in a qualified trade or business. Specifically, the deduction amount is the lesser of 1) 20% of total QBI, plus 20% of qualified REIT dividends, plus 20% of qualified PTP income; or 2) 20% of a taxpayer’s taxable income computed before the QBI deduction, minus net capital gains [Treasury Regulations section 1.199A-1(a)(2)]. By definition, QBI must pertain to one or more domestic trades or businesses, other than as a result of owning stock in a C corporation or engaging in the trade or businesses as an employee. Qualified domestic trades or businesses include sole proprietor-ships, S corporations, limited liability corporations, partnerships (including PTPs), and REITs.
The application of IRC section 199A centers on the taxpayer’s threshold amount. For any tax year beginning before 2019, the threshold amount is $157,500 ($315,000 for a joint return). The threshold amount will be adjusted annually by multiplying the cost-of-living adjustment determined under IRC section 1(f)(3). If the taxpayer’s taxable income before the QBI deduction is below the threshold amount, the taxpayer may take the deduction, provided that the income is generated by a domestic trade that is not a C corporation. There is no ceiling other than the 20% limitation on the total QBI, subject to certain limitations or an amount equal to 20% of the excess, if any, of the taxable income over the net capital gains for the current tax year. If the QBI after aggregating all activities is less than zero for the taxable year, the amount of loss is carried forward to future tax years.
There are limitations on the QBI deduction if the taxpayer’s taxable income before the deduction exceeds the threshold amount. The first limitation is the type of trade or business that qualifies for the deduction. Pursuant to the proposed Treasury Regulations section 1.199A, if the trade or business is a specified service trade or business (SSTB), no part of the business can be used in the calculation of the QBI deduction. Thus, certain types of service businesses are disqualified if the taxpayer’s modified taxable income exceeds the threshold amount. IRC section 199A defines an SSTB to include any trade or business that “involves the performance of services in” a specified service activity. This definition is consistent with “qualified personal service corporation” under IRC sections 1202(e)(3)(A) and 448.
There are limitations on the QBI deduction if the taxpayer’s taxable income before the deduction exceeds the threshold amount.
Pursuant to IRC section 1202(e)(3), the business or trade’s principal asset is the reputation or skill of one or more of its employees. This rule will disqualify most professional services in the fields of health, law, accounting, consulting, athletics, financial services, and the performing arts. By the provisions of IRC section 199, services in the areas of engineering and architecture are excluded from this rule and can be used for the QBI deduction if all other criteria are met.
If the business or trade is not deemed an SSTB, but the taxpayer exceeds the income threshold, the deduction is calculated as noted above. Once calculated, the QBI deduction is further limited by the greater of 50% of the wages paid with respect to the qualified trade or business, or the sum of 25% of the wages paid plus 2.5% of the unadjusted basis immediately after the acquisition of qualified property held available for use by the trade or business. If the taxpayer exceeds the threshold amount and no wages are paid by the trade or business, the deduction is limited to 2.5% of the unadjusted basis of qualified property. If the trade or business has no wages or qualified property, the deduction is zero. “Qualified property” refers to tangible, depreciable property. The property is disqualified if it is acquired within 60 days prior to the end of the tax year or disposed of within 120 days without being used for a minimum of 45 days prior to the disposition. Therefore, the timing of property acquisition is critical for taxpayers that rely on the 2.5% of qualified property provision to calculate their respective QBI deductions. Even though property must be within the normal depreciation period for the asset in order to be counted toward the depreciable property threshold, electing additional first-year depreciation will not reduce the normal depreciation period for these purposes. Therefore, taxpayers do not have to worry about any negative impact from taking additional first-year depreciation regarding IRC section 199A.
General QBI Tax Planning Strategies
One tax planning strategy regarding the QBI deduction is the use of grouping elections that are beneficial to taxpayers. Grouping elections for the section 199A deduction allow taxpayers to aggregate business activities so that they can maximize income from qualified businesses in order to maximize the QBI deduction. In order to aggregate business activities, two primary conditions need to apply. First, the same person or group of persons must, directly or indirectly, own 50% or more of each trade or business for a majority of the tax year. Second, two out of the three following conditions must apply:
- The businesses provide services and products that are typically offered together.
- The businesses share centralized business elements or facilities.
- The businesses are operated in coordination with one or more of the other businesses in the aggregated group.
While these provisions limit a taxpayer’s ability to aggregate unrelated businesses, several productive tax planning opportunities still exist. For example, a taxpayer could use recently purchased high-basis property to prevent the QBI deduction from being reduced by older property used in other activities that has been fully depreciated.
The proposed regulations for IRC section 199A also affect the desirability of other tax provisions and business structures. For example, property acquired in a section 1031 exchange has a tacked-on depreciation period for purposes of computing the depreciable life of the asset for the QBI deduction; newer property therefore will not be available to increase the unadjusted basis of property when computing the QBI limitation, making section 1031 less desirable. In addition, gain or loss treated as capital gain (or section 1250 gain) is not included as qualified business income; however, IRC section 1245 gain included as ordinary income is classified as qualified business income. Taking additional accelerated depreciation deductions (such as section 179 or bonus depreciation) therefore may be especially beneficial in this environment.
QBI Advantages for Indirect Real Estate Investors
Despite the wage and property considerations, there is an exception for taxpayers who exceed the threshold amount under IRC section 199A. For individuals and some trusts and estates, taxpayers may deduct up to 20% of their combined qualified REIT dividends and qualified PTP income. This exception makes REITs and PTPs much more attractive investment vehicles. The QBI deduction is typically not available to those who only receive passive investment income (e.g., dividends, interest, capital gains). REITs traditionally invest primarily in commercial real estate or real estate financing and can either be publicly or privately traded; the inclusion of REITs in the QBI deduction therefore provides passive investments with tax advantages similar to an active trade or business.
The deduction will be highly beneficial to many taxpayers, including those that engage in real estate transactions.
Investments in REITs can be advantageous to taxpayers for other reasons as well. First, despite their status as corporate entities, REITs are not taxed on income at the entity level. Second, REITs are required to distribute 90% or more of their taxable income as dividends. In addition, the wage and income limitations are not applicable to those who receive income from a REIT. Qualified REIT dividends are not classified as QBI income under section 199A; they are instead a separate type of income eligible for the QBI deduction. QBI losses therefore do not reduce qualified REIT dividends, thus maximizing a taxpayer’s QBI deduction. Qualified REIT dividends must, however, be reduced by losses from qualified PTP income.
QBI Advantages for Direct Real Estate Investors
Taxpayers who directly invest in real estate may also benefit from the QBI deduction, although there are several hurdles to overcome. First, a taxpayer’s real estate involvement typically needs to meet the definition of a trade or business in order to attain the IRC section 199A deduction. Real estate investors therefore must engage in real estate investment activities with regularity and continuity in order to receive the tax benefit. The taxpayer must also have a profit motive and cannot be a sporadic participant in the business.
One such strategy applies if the taxpayer meets the definition of a real estate professional. Pursuant to IRC section 469(c)(7)(B), a taxpayer is considered a real estate professional if 1) more than one-half of the total personal services the taxpayer performs in trades or businesses are performed in real property trades or businesses in which the taxpayer materially participates and 2) the taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.
The examples cited in the regulations indicate that, while a taxpayer owning only one property would be ineligible for the deduction, a taxpayer owning several properties would qualify. The regulations also indicate that regularly employing an individual (either as a W-2 employee or a 1099 contractor) to interact with tenants or make repairs would also be extremely helpful in achieving trade or business status. The properties owned by the taxpayer can generally be improved or unimproved, and in many cases, the owner/landlord may not be required to do more than negotiate leases and cash checks. If a taxpayer owns a building that he rents to his own business, then the rental activity will be considered a trade or business regardless of the taxpayer’s level of involvement; such a taxpayer is unlikely to need to attain the trade or business threshold needed under the passive activity rules of IRC section 469 in order to take the QBI deduction. Taxpayers trying to meet the criteria of the section 199A deduction should, however, generally take an active role in managing their properties or purchase several similar properties, in order to be certain that they can obtain the deduction. Taxpayers should also carefully document their time spent managing real estate properties (e.g., paying bills, searching for tenants).
Winning QBI Strategies
While the exact application of the IRC section 199A provisions to the QBI deduction is ambiguous, the deduction will be highly beneficial to many taxpayers, including those that engage in real estate transactions. There are also certain strategies that taxpayers can utilize to maximize their deduction potential. In order to achieve the maximum benefit of the QBI deduction, taxpayers should increase their involvement in real estate investment activities, increase their basis in real estate assets, decrease their involvement in section 1031 exchanges, take advantage of accelerated depreciation deductions, or directly employ more individuals.