Tax Considerations for Real Estate Investors: How Does the Qualified Business Income Deduction Apply to Real Estate Businesses?

General Qualified Business Income Deduction

Under the tax reform legislation passed in December 2017, individuals with business income from pass-through entities (partnerships, LLCs, S Corporations and sole proprietorships) may qualify for the new Qualified Business Income Deduction under new IRC Section 199A. Qualified Business Income (QBI) is defined as the net amount of qualified income, gain, deduction and loss with respect to any “qualified trade or business” of the taxpayer. For taxpayers with taxable income under $315,000 for married filing jointly, or $157,000 for all other taxpayers (the thresholds), the deduction is the lessor of 20% of QBI or 20% of the amount by which taxable income exceeds capital gains (the taxable limitation below), regardless of the type of business generating the QBI.

For taxpayers exceeding these thresholds, the calculation is much more complicated. For these taxpayers the deduction is the lesser of:

1. 20% of QBI with respect to the qualified trade or business: or
2. The greater of:
   1. 50% of W-2 wages with respect to the qualified trade or business; or
   2. The sum of 25% of W-2 wages with respect to the qualified trade or business plus 2.5% of the unadjusted basis of qualified (depreciable) property.

The deduction is then subject to a taxable income limitation equal to 20% of the excess of:

1. Taxable income for the year, over
2. The sum of net capital gain, if any.

The reduction of taxable income by net capital gains is to prevent the 20% deduction from being taken against income taxed at preferential capital gain rates.

For taxpayers whose taxable income exceeds the thresholds and whose businesses are classified as “Specified Service Trade or Businesses” (SSTB), it is even more difficult to claim the QBI deduction. SSTBs are generally professional service-oriented trades or businesses such as accounting firms, law firms, medical practices, consulting businesses, and financial advisors but not architectural and engineering firms. If the taxpayer’s taxable income exceeds the limits, the QBI deduction is fully phased out for the SSTB income when taxable income exceeds $415,000 for married filing joint and $200,500 for all other taxpayers.

How does the Qualified Business Income Deduction Apply to Real Estate Businesses? 

When the tax reform act was passed, there was speculation about what kind of real estate investments would be a qualified trade or business under Section 199A. Recently, the IRS issued the proposed regulations for Section 199A, which have provided some clarity on the application of the Qualified Business Deduction to the real estate industry which were generally very favorable to the industry. Some conclusions from the proposed regulations include:

1. Real estate leased to a commonly controlled (50% or more) trade or business that is not an SSTB is “deemed” to be a trade or business.
2. It is likely that rental property leased under triple net leases do not qualify as a trade or business under Section 199A. Lessors might want to reevaluate these leases to increase the involvement by the landlord and avoid triple net leases.
3. Investors need to track the activities and time spent in the real estate business by themselves and their employees or agents working in the rental activity. This can include time spent paying bills, doing accounting, hiring vendors to maintain and improve the property, inspecting the property and approving tenants.
4. The more rental units or properties a taxpayer has, the greater change the IRS will consider the activity to be a trade or business.
5. Taxpayers with minimal involvement in the rental activities will possibly be challenged by the IRS that they qualify for the QBI deduction.

Based on the proposed regulations, just owning real estate is not sufficient to qualify for the QBI deduction. Investors must truly operate the real estate investments as a business of real estate to take the QBI deduction.

Once a taxpayer determines that their real estate investments qualify for the QBI deduction, many will face another hurdle if their taxable income exceeds the threshold amount. Since real estate rental businesses typically do not pay wages, higher income real estate investors’ QBI deduction might be limited by the wage and depreciable property limitation discussed earlier.

The amount of “unadjusted basis” of depreciable property includes only tangible, depreciable property, so the land portion of the real estate is excluded from this calculation. Additionally, the property must be owned at the end of the year. So, if real estate investors are selling their property, they might want to consider deferring the sale until the next taxable year to take the QBI deduction.  On the positive side, the depreciable property limitation is based upon the “unadjusted basis” so depreciation deductions over time do not reduce the amount of qualified property.

Depreciable property is included in the calculation only during the “qualified period” which is the longer of ten years or the depreciable period. Since real estate is generally depreciated over 27.5 years for residential property and 39 years for commercial property, they will be included in the calculation for a long period of time, but once the property has been fully depreciated, it is no longer included in the calculation. This limitation could impact taxpayers operating rental businesses in which the rental property was purchased many years ago.

One rule that might help real estate investors increase their QBI deductions is the aggregation rule.  Under the proposed regulations, multiple trades or businesses may be combined for testing purposes if:

1. The same person or groups of persons directly or indirectly, own 50% or more of each trade or business for most of the tax year.
2. All the items attributed to each trade or business to be aggregated are reported on returns with the same taxable year.
3. The trade or businesses are not SSTBs.
4. At least two of three factors must apply:
   1. The businesses provide product or services that are customarily offered together,
   2. The businesses share facilities or significant centralized business elements.
   3. The businesses are operated in coordination with, or reliance upon, one or more of the businesses in the aggregated group.

The aggregation rules could help taxpayers subject to the wage or wage and undepreciated property limitations to possibly qualify for a larger QBI deduction by combining the related businesses’ wages and unadjusted basis. However, once businesses have been aggregated, they must remain aggregated unless there is a change in circumstances such that they no longer qualify for aggregation. So, both current and future tax situations must be considered before electing aggregation.

Key Takeaways 

The Qualified Business Income Deduction can lower the maximum tax rate for taxpayers from 37% to 29.6%. This can significantly impact the taxes of business owners, including real estate investors.

Additionally, there are many planning opportunities associated with the Qualified Business Income Deduction for both real estate and other businesses. Taxpayers should consult with their Sikich tax advisor to determine how they can qualify for and maximize this new deduction.