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The Tax Cuts and Jobs Act created a potentially valuable deduction for small business owners, self-employed individuals, and real estate investors. It's known as the Qualified Business Income (QBI) deduction, or more commonly as the pass-through tax deduction.
What is the pass-through tax deduction?
The simple version is that qualified individuals get as much as a 20% deduction from their income from pass-through entities like LLCs and partnerships. There are income limitations and complex ways of determining the deductible amount for taxpayers who exceed them, but that's the basic idea.
There are some rules regarding who can use the deduction and what types of income qualify. We'll talk about those soon.
Here's what U.S. taxpayers need to know about the new pass-through tax deduction, who might be able to use it, important rules to know, and some examples of how the QBI deduction is calculated.
What is the pass-through tax deduction? A detailed answer
Formally known as the Section 199a Qualified Business Income Deduction, and also called the QBI deduction, the pass-through tax deduction is designed to encourage Americans to start small businesses and engage in other entrepreneurial ventures.
In a nutshell, it treats income that comes from certain non-employer sources in a favorable manner.
This was part of the Tax Cuts and Jobs Act, which went into effect for the 2018 tax year. Like most of the provisions in this tax reform bill that affect individuals, it's scheduled to end after the 2025 tax year.
Specifically, the pass-through tax deduction lets U.S. taxpayers deduct as much as 20% of their business income that comes from "pass-through" entities. This includes, but isn't necessarily limited to:
- partnerships, and
- sole proprietorships.
A pass-through business is generally defined as one that doesn't pay any taxes itself, but rather passes its income (and therefore its tax liability) to its owners. Regular corporations, also known as C-corporations, never qualify for the IRS pass-through deduction, even if the company is a small business. However, the Tax Cuts and Jobs Act permanently lowered the corporate tax rate from 35% to 21%.
In other words, if you earn $50,000 from freelance consulting work, you might be able to deduct as much as $10,000, lowering your income tax liability. You'd pay less tax on this income than if you had earned the same amount from an employer.
As a general guideline, the IRS has typically defined a business as an activity conducted regularly and with a realistic goal of earning a profit. It's also worth mentioning that you don't necessarily need to participate in the business that produces the income to take the deduction. For example, if you own one-third of a retail business but don't play an active role in it, any income you receive from the business could still potentially qualify.
It's also important to mention that the pass-through deduction isn't an itemized deduction -- but it isn't an above-the-line deduction either. This means you don't need to itemize deductions to take advantage of it, but it doesn't have the additional effect of reducing your adjusted gross income (AGI). Other above-the-line deductions, such as those for IRA contributions and student loan interest, do.
We'll get into the specific rules of the deduction later on, but this is the general idea of what the pass-through tax deduction is and how it works.
Who qualifies for the 20% pass-through deduction?
At this point, you might be wondering why a tax deduction designed to help small business owners would have implications for real estate investors.
For one thing, if you own rental properties, you technically are operating a small business. And any taxable rental income you receive meets the definition of qualified business income. That's on top of the other tax benefits of owning real estate. So you can deduct your operating expenses and depreciation to lower your rental income tax and then apply the 20% pass-through deduction to reduce your tax liability even further.
There's good news for real estate investment trust (REIT) investors, as well. While you wouldn't think that REIT dividends qualify for the deduction -- after all, they're a form of stock dividends -- the fact is that REITs themselves are pass-through entities.
In exchange for their favorable corporate-tax-free treatment, REITs must distribute a minimum of 90% of their taxable income to shareholders. In practice, most distribute all of it. They pass their income through to investors just like an LLC or S-corporation does.
In fact, the IRS has specifically said that REIT dividends are qualified business income and are eligible for the deduction. One caveat is that because REIT dividends can be a little complicated and are often made up of a combination of several types of income, not all of your REIT distributions will necessarily qualify.
Each REIT publishes a statement shortly after the end of the year detailing the tax treatment of its distributions for the year. You can also get this information from your broker's year-end tax documents.
Other types of real estate investment income could be eligible, as well. If you participate in a crowdfunded real estate opportunity, for example, income distributions you receive might be eligible for the pass-through deduction. However, if you receive a lump sum at the end of the investment (say, when the property you invest in is sold), it's generally treated as a capital gain, not as business income. Like with REITs, the tax documents you receive each year should tell you how the money you received will be treated by the IRS.
Pass-through tax deduction rules you need to know
To take advantage of the pass-through deduction, you need to have pass-through income. In a nutshell, this refers to business profits -- that is, the amount you make when adding up all your revenue and subtracting your deductible business expenses.
Importantly, pass-through income does not include the following:
- Short- or long-term capital gains, even if they're generated by a pass-through business. For example, if you sell your business for more than you paid to acquire or start it, that's a capital gain, not business income.
- Dividends or interest income. REIT dividends are an exception, since REITs are pass-through entities.
- Wage income you're paid, even if it's from a qualified business type like an S-corporation. If your income was reported on a W-2, it's probably not qualified business income for the purposes of this deduction.
The pass-through deduction is based on your overall net business income or loss, which is an important concept to understand if you have a few qualifying income sources.
For example, if you have $20,000 in qualified income from a convenience store you own, $5,000 from a rental property, and a $30,000 loss from another business, you would have a net loss of $5,000 per year and couldn't use the pass-through deduction. In other words, you can't choose to take the deduction only for your profitable businesses.
Furthermore, if you have a qualified business income loss for a given year, you must carry the loss over to the next tax year. Continuing our previous example of a $5,000 loss, let's say you have a net QBI profit of $30,000 the next year. You'd need to apply the $5,000 loss, reducing your deductible qualified business income to $25,000.
You also need to have taxable income. This sounds rather obvious -- after all, to deduct something from your taxable income, you need to have taxable income in the first place. However, if you have qualified business income but your other deductions (e.g., the standard deduction) leave you without any taxable income, you can't use the 20% pass-through deduction.
A simple example of the 20% pass-through tax deduction
Before we go any further, let's look at a simple example. We'll say you earn a salary of $70,000 in 2019 from your job and $30,000 from consulting work you do on the side, which is paid to you through an LLC. After accounting for your other deductions, you're in the 22% tax bracket.
The pass-through deduction allows you to deduct $6,000, or 20% of your consulting income. Because you're in the 22% tax bracket, you save $1,320 on your taxes for the year.
Who doesn’t qualify for business deductions?
It's important to note that not everyone who has pass-through income can take advantage of this deduction. There are income limitations for taxpayers whose income is from certain "specified service" businesses. For example, doctors and lawyers who operate their own practices are included in the specified service definition and are subject to income limitations when it comes to the pass-through deduction.
It's easy to see why this limitation exists. The pass-through deduction was intended to reward Americans who start and operate businesses, not to give tax relief to highly paid professionals who happen to be self-employed.
Here are just some of these service businesses:
- Health professionals
- Performing artists
- Consulting services
- Financial services
- Brokerage services
- Investment management businesses
- Any business with a principal asset of the reputation or skill of its owner(s) or employee(s). This includes businesses where income results from endorsements of products or services; licensing of the owner's image, likeness, or other characteristics; or if the primary income source is from the owner making media or event appearances.
For taxpayers in 2019 whose pass-through income comes from one of the specified service businesses, the deduction begins to phase out above taxable income of $321,400 for those married filing jointly or $160,700 for all others. The keyword in that last sentence is "phase out." Taxpayers whose income exceeds these thresholds can potentially get some deduction. And these thresholds will be adjusted for inflation in 2020 and subsequent years.
Unfortunately, calculating the deduction becomes considerably more complex above these thresholds.
If you're not in one of the listed service businesses but your income exceeds the phase-out threshold
If you exceed the phase-out threshold by $100,000 or more ($50,000 for individuals), a special rule applies, known as the W-2 wage/business property limitation. For 2019, this happens if your taxable income is greater than $421,400 (joint return) or $210,700 (everyone else).
In this case, your deduction would be limited to the greater of
- 50% of your share of W-2 employee wages paid by the business or
- 25% of your share of W-2 wages plus 2.5% of the acquisition cost of your business property.
Of course, the deduction is still limited to a maximum of 20% of your qualifying pass-through income.
Let's say you own a property management business that's structured as an LLC with you as the sole owner. Property management isn't on the exclusion list above. Your business income is $300,000 and, combined with a spouse, your total taxable income is $450,000. You own business assets worth $250,000 and paid three employees a total of $100,000 in W-2 wages during the year in question.
So, 20% of your qualified business income would be $60,000. By the 50%-of-wages method, your deduction would be limited to $50,000. By the other method, 25% of W-2 wages plus 2.5% of business property, your deduction would be limited to $31,250. Because you can use the higher of the two, you'd be allowed to deduct $50,000 of your business income.
Note that if you don't have any W-2 employees or business property, you can't use the deduction at all if you're in excess of the threshold. However, most real estate businesses own depreciable property, so even if you have very high income, you'll likely be able to take a pass-through deduction for your real estate business income.
If your taxable income is between $321,400 and $421,400 for a joint return or $160,700 and $210,700 for an individual tax return, the W-2 wages/business property rule only applies to some of your qualified business income deduction -- the rest can be deducted at the full 20% rate. In other words, your deduction will be somewhere between the limited deduction method and the full 20%.
If you are in one of the listed service business and your income exceeds the threshold
If your taxable income is greater than the applicable threshold and you operate in one of the specified service businesses, your deduction begins to phase out. Above taxable income of $421,400 (joint return) or $210,700 (all others), you can't use the qualified business deduction at all.
If you're between the lower and upper thresholds that apply to you (so, between $321,400 and $421,400 in taxable income for those married filing jointly and between $160,700 and $210,700 for everyone else), there's a two-step process for calculating the deduction.
First, use the two-part W-2 and business property formula I discussed in the last section to calculate your deduction before the phase-out. Then, reduce your deduction by 1% for every $1,000 you exceed the phase-out threshold by (2% if you don't file a joint return).
If that sounds complicated, it's because it is. Here's as simple of an example as I can give you.
Let's say you're a physician and own your practice. You have qualified business income (QBI) of $300,000 and, combined with your spouse, you have taxable income of $341,000 -- exactly $20,000 over the phase-out threshold. You own business assets worth $500,000 and have W-2 employees who earn a total of $100,000.
First, use the greater of the two-part method to calculate your deduction before the phase-out.
- 50% of the W-2 earnings is $50,000.
- 25% of the W-2 earnings plus 2.5% of your business assets is $37,500.
Now, 20% of your qualified business income would be $60,000, but this method would limit your deduction to $50,000.
However, remember that you're $20,000 over the phase-out threshold and your deduction is reduced by 1% for every $1,000. So, reducing the $50,000 deduction you calculated by 20% gives you a pass-through deduction of $40,000.
The bottom line on the pass-through tax deduction
The pass-through tax deduction can result in serious tax savings for small business owners and real estate investors, especially if you can deduct the full 20% of your qualified income. This can make real estate -- which is already a very tax-advantaged investment -- even more attractive.
As a final thought, you may have noticed that the pass-through deduction is very complex and has many gray areas. After all, the IRS guidance on the deduction is 248 pages long and isn't exactly easy to follow. In 2,500 words, I've only scratched the surface of some of the what-ifs.
If you aren't sure about the eligibility of any of your pass-through income, consult a tax professional to make sure you get it right.
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