Planning strategies do exist to qualify situations for the 20% deduction – almost 199A of them!
Most real estate investors and business people are well aware that new Internal Revenue Code Section 199A allows a 20 percent deduction for certain types of income, and that the real estate industry was favored under these new rules.
The issuance of new Proposed Regulations on August 8th answers many questions and raises others about how these rules impact real estate and real estate professionals, while presenting both planning opportunities and traps for the unwary that need to be considered by real estate investors, developers, and companies that are in real estate, or real estate-related trades or businesses. The Proposed Regulations are sure to change to some degree before they become final, but can be relied upon by taxpayers until then. On the other hand, parts of the Regulations that would hurt taxpayers need not be followed until they are made final, but reflect how the IRS is looking at the statute and how it may be interpreted.
The 20 percent deduction will apply to individuals, trusts, and estates that have “Qualified Business Income” from individual ownership, ownership of LLCs that are disregarded for income tax purposes, and income that is received via K-1 reporting from S Corporation and partnership ownership, subject to limitations that are discussed below.
The deduction only applies to ordinary income that comes from an active trade or business. It does not apply to short term or long term capital gains income, or to foreign income (Puerto Rico is not considered to be foreign), and the deduction cannot exceed the total net taxable income for the calendar year for the taxpayer, so that losses from one or more businesses or activities can cause a reduction or loss of the Section 199A deduction. In sum, because the total net taxable income includes income sources that are not considered by the deductible, the deductible can sometimes be larger than the total net taxable income after losses are accounted for. Since the deductible cannot exceed the total net taxable income, the deductible will be reduced or, in some cases, eliminated following these losses. Also, the deduction does not reduce income for the purposes of calculating employment taxes or the 3.8% Net Investment Income Tax, which will now need to be calculated independently. Independent contractors who report their income on the Schedule C of the individual 1040 tax return will normally be subject to the 15.3% employment tax on the first $128,400 of income, without regard to the 20 percent 199A deduction.
The deduction does not apply to wages paid to an employee, or compensation earned by someone who reports the income as an independent contractor, but is found by the IRS to actually be an employee under the test described below.
Normally, single filing individuals, trusts and estates with taxable income of less than $157,500, and married couples filing joint returns with taxable income under $315,000 will qualify for the deduction with no questions asked as to whether the applicable activity or entity satisfies certain wage and qualified property hurdles which apply for high earner taxpayers, as discussed below.
As the result of the above, an independent real estate broker, developer, contractor, or subcontractor engaged in the normal activities of those professions will typically qualify for this 20 percent deduction. For real estate leasing operations, the deduction will be based upon taxable income, which generally means the amount by which rent income exceeds the sum of (1) operating expenses, (2) interest deducted and (3) depreciation deductions.
One thing we have been very anxious to know is whether a passive landlord who collects rent under a triple net lease will be considered to be in the “trade or business” of leasing in order to qualify any positive taxable income for the Section 199A deduction.
The Proposed Regulations tell us that a “trade or business” will exist if the “active trade or business” requirements of Internal Revenue Code Section 162 are met. The Section 162 rules have been around since 1926 and basically allow expenses to be deducted when incurred for a legitimate and active trade or business.
There is remarkably little case law or IRS interpretative references available to determine if and when the leasing of property will be considered to be a trade or business. It appears that a landlord who simply owns a property and does nothing but receive rent on a long-term triple net lease will not be considered to be in a “trade or business” unless or until that property owner engages in more activities, which might include actively working to purchase more investment property, and working to buy or sell or contract out rights concerning triple net leased property in the same manner as a “dealer” who works to sell real estate. As a result, many landlords will renegotiate terms with the tenants to have a more active role and responsibility in administering common area maintenance, being involved in tenant build outs and activities and otherwise acting like an active trade or business.
There is a valuable exception, however, under the Proposed Regulations which permits even passively held triple net leased property to be considered as an active business activity to the extent that the property is leased to another active trade or business that taxpayer has direct or indirect ownership, if the taxpayer and/or parties related by family attribution or common ownership of the business tenant own more than 50 percent of the business tenant. If the income comes from multiple tenants, one being a related party and the other an unrelated party, then only the portion attributable to the related party will automatically be considered an active trade or business, and the landlord will have to do more than just collect rent from the unrelated party in order for that portion to be considered an active trade or business and eligible for the Section 199A deduction.
A passive triple net leased arrangement will nevertheless be considered to be an active business if the property is leased to an active trade or business when there is 50% or more common ownership between the Landlord and the Tenant according to the Proposed Regulations.
Section 199A coined the term “Specified Service Trade or Business” (SSTB) and provides that individuals, trusts and estates that have income derived from SSTBs will not qualify for the deduction if the individual trust or estate has taxable income exceeding $207,500 (or $415,000 with respect to a married couple filing jointly), and there is a ratable phase out of the deduction where the income is from a SSTB and the Taxpayer has income between $157,500 and $207,500 if filing single, or $315,000 and $415,000 if married filing joint.
Fortunately, real estate professionals, including brokers, agents, developers and property managers are not considered to be SSTBs, although if the real estate is used and rented by a SSTB and is 50% or more commonly owned by owners of the SSTB and the landlord, then the real estate and the SSTB are aggregated and both ineligible for the Section 199A deduction if their income exceeds the above thresholds. Another blog post that I have recently posted describes what the Specified Trades or Businesses are, and what can be done for those who are under this limitation. The most common ones include doctors, lawyers, accountants, consultants and financial services companies, and can be viewed by CLICKING HERE.
Individual taxpayers, trusts and estates that have taxable income greater than these $215,000/$415,000 thresholds will also not receive a deduction on pass through income unless the income has sufficient associated wages and/or Qualified Property, based upon the apparent intent to encourage businesses and business people to pay wages to employ Americans or to have property of fairly recent vintage in order to obtain the deduction.
The amount of the deduction as to the Qualified Business Income will be no more than the greater of (a) 50 percent of wages paid by the applicable trade or business or (b) the sum of (i) 25% of wages paid, plus (ii) 2.5 percent of the “Unadjusted Basis” (generally the cost of the property) of property used in the trade or business.
For example, if an S Corporation that has $200,000 of income that pays $70,000 in wages is owned by an individual, single filer making more than $207,500, then the deduction will be limited to $35,000. Alternatively, if the S Corporation paid no wages and has a building originally purchased for $1,400,000, then the deduction would also be limited to $35,000. Under either scenario, the S Corporation could acquire more property or pay more wages in order for the individual to qualify for the full deduction.
Wages can include wages paid to the taxpayer by an S Corporation owned in whole or in part by the taxpayer, but compensation paid from a partnership to a partner who works in the partnership will not be considered to be wages, although there are ways around this limitation, such as by having the taxpayer establish an S Corporation which in turn owns the partnership interest so that wage payments made by the partnership to the individual owner are not considered to have been made “to a partner”.
Wages for this test also include most forms of contributions to pension and 401(k) plans and employer provided health insurance and many other employee benefits.
As the result of the above, a high earner real estate broker (we refer to individuals, trusts and estates that are above the $157,500/$315,000 thresholds as high earners) will need to pay out wages that come out to be about 28.57% of what her net income from the brokerage would be to have the 20% deduction apply to her non-wage income. Most brokers will continue to use S Corporations so that the remaining income comes out as dividends that are immune from the 3.8% Net Investment Income Tax and employment taxes.
Real estate professionals who are employees may consider becoming independent and setting up S Corporations to hire the person to provide services to their former employers, but the Proposed Regulations provide that individuals who have been treated as employees will be presumed to continue to be employees if they are continuing to work primarily for the same employer, even if this is done through another entity like an S Corporation. Therefore, this tactic of becoming independent and setting up S Corporations may not always be a viable method of increasing a professionals Section 199A deductible.
A separate blog post will discuss how to try to make sure that a taxpayer is treated as an independent contractor as opposed to an employee, and the following chart will be included in that post, and should be of assistance in structuring.
|Common LawTest Factor||Behavioral Control||Financial Control||Relationship of the Parties|
|1||Compliance with instructions||X|
|4||Services rendered personally||X|
|5||Hiring, supervision, and paying assistants||X|
|6||Set hours to work||X|
|7||Full time required||X|
|8||Doing work on employer’s premises||X||X|
|9||Order or sequence test||X|
|10||Oral or written reports||X|
|11||Payment by the hour, week, or month||X|
|12||Payment of business and/or traveling expenses||X|
|13||Furnishing tools and materials||X|
|15||Realization of profit or loss||X|
|16||Making services available to the general public||X|
|18||Working for more than one firm at a time||X|
|19||Right to discharge||X|
|20||Right to terminate||X|
A future post will discuss how like kind exchanges, the death of a taxpayer and the partnership tax rules impact this planning. Please stay tuned and make sure that you have a competent tax advisor or advisors to weigh in on how to best structure these arrangements, but do not expect an immediate answer, or that your situation can be restructured without some research and careful thought…and for the most part, the new regulations have not made this easier.
Realtors aren’t the only ones who need closure, so let’s hope the IRS liberalizes its approach and stay tuned.
You can get a copy of our white paper on Section 199A planning by contacting me at email@example.com.
I will be speaking on Section 199A at the following conferences – in case you would like to have a tax deductible trip and support a worthy not-for-profit organization:
Notre Dame Tax Institute, South Bend Indiana – October 12, 2018
Contact: Jerome Hesch – firstname.lastname@example.org
Federal Tax Institute of New England, Portland Connecticut – October 18, 2018
Contact: Deborah J. Tedford – DTedford@mysticlaw.com
Florida Institute of Certified Public Accountants (FICPA), Tampa, Florida – October 25, 2018
Contact: Nathan Wadlinger (USF) – email@example.com
American Academy of Attorney – Certified Public Accountants (AAA-CPA), Miami, Florida – November 5, 2018
Contact: Jo Ann Koontz – Joann@koontzassociates.com