My August 28, 2018 post discussed how the new Section 199A 20% deduction rules apply for real estate investors and professionals, and referred to certain other rules to be covered in a future posting. You can review that post by clicking here.
By way of brief review, the Section 199A deduction allows up to a 20% deduction from net income received from a qualified trade or business. The active rental of real estate, being a dealer or developer in real estate, and other associated activities and vocations can qualify, but several special rules apply.
This may be best described by an example.
Assume that Jane Buildart is a real estate investor who has a consulting and brokerage firm that provides services to people who want to buy and sell real estate. She receives most of her income from commissions on her sales and the sales of her employees. In addition, she owns ten rental properties that are conducted under ten separate L.L.C.’s which are each disregarded for income tax purposes, causing the net rental income to be reported on her Form 1040 personal income tax return.
Jane has a positive net income for all of her properties because she has very little debt and the rental income exceeds her depreciation, interest and other expense deductions each year. Her brokerage firm is taxed as an S Corporation and pays her a reasonable salary. She also has a net dividend/K-1 income above and beyond the salary.
If Jane has a total net income of less than $157,500 and she files as a single individual or as married filing separately, or if Jane is married and she and her spouse have less than $315,000 in total taxable income on their joint tax return, then she will qualify for the 20 % deduction on net income from the active leasing of real estate and her brokerage firm activities if her rental activities are active enough to be considered as one or more “active trades or businesses” under the definition set forth in Internal Revenue Code Section 162.
Triple Net Leased Properties
As discussed in a previous article, which can be found here, when properties are triple net leased with no active management or other obligations or activities that would make them an active trade or business, the net income from non-active rental properties would not be eligible for the deduction.
If Jane’s ten rental properties mentioned above are triple net leased and, as a landlord, Jane does not engage in an active managerial or some kind of business activity associated therewith, such as actively buying and selling rental properties, then the 20% deduction will not be available.
In addition, the Section 199A deduction cannot exceed the ceiling limit of 20% of her total net income, or the total marital net income if she and her spouse file a joint return, so that losses from other activities may reduce the Section 199A deduction that would otherwise apply for her.
High-Income Taxpayers and the Wage or Qualified Property Test
The deduction changes if Jane’s income is above $207,500, if she is a single filer, or $415,000, if she files jointly with a spouse. If Jane’s income is above these levels, then she cannot take any deduction under Section 199A, unless there are sufficient wages or qualified property basis to satisfy the wage or qualified property test. This test that applies to high earners limits the Section 199A deduction to the greater of 50% of the taxpayer’s share wages paid by the Section 199A businesses or the sum of (a) 25% of wages and (b) 2.5% of the taxpayer’s share of the unadjusted basis of qualified property.
If Jane’s personal taxable income is between the base of $157,500 and the ceiling of $207,500 if single, or between $315,000 and $415,000, if married filing jointly, and if the wage or qualified property test described above is not satisfied, a “phase out” occurs that is generally in proportion to where the income lays between the two amounts, without regard to whether the wage or qualified test applies. If the wage or property test is partially satisfied, then the phase out calculation becomes even more complicated.
In addition, Jane’s deduction could be limited by the fact that she provides some consulting services, which is considered as specified service, trade or business. There is a de minimis exception that applies if her gross receipts from consulting is less than 10% of the combined receipts of the consulting and brokerage firm activities. If this exception is satisfied, then the consulting income will not be considered as specified service trade or business income, and thus eligible for the Section 199A deduction, if the requirements discussed above are satisfied. If the firm has more than $25,000,000 a year in volume, then the de minimis threshold would be reduced to 5% of gross receipts.
If the consulting income exceeds these thresholds, then the income attributable to Jane’s consulting services will not be eligible for the deduction.
Many assumed that each separate entity would have to stand on its own for purposes of passing these tests, but the Proposed Regulations issued in August permit the taxpayer to aggregate two or more entities or activities. This allows wages and qualified property to be considered as paid for all of the entities so that the deduction can be taken for income received from a partnership, an S Corporation or a proprietorship that has little to no wages or qualified property if owned by the same taxpayer who has other entities with more than enough wages or qualified property.
For example, if 50% of the wages paid by Jane’s S Corporation exceeds what the Section 199A deduction would otherwise be from all 11 entities, then she can take the deduction for all 11 entities. Alternatively, she can aggregate only those entities that she wishes to aggregate, as long as she or some any other person owns 50% or more of each entity that is aggregated, and the entities are interrelated to one another. Once entities are aggregated by a given taxpayer, they cannot be taken apart again for Section 199A purposes, according to the Proposed Regulations.
Unadjusted Basis of Qualified Property
Landlords who are active enough to qualify for the deduction will have to pay wages to the extent that 2.5% of their unadjusted basis of qualified property is not sufficient to meet the deduction requirement.
The unadjusted basis of qualified property is the original depreciation basis of assets used in the trade or business, which means the original cost, plus improvements, without reduction for depreciation taken. This does not include assets such as land, which is normally not depreciable, notwithstanding the expenses paid to develop land can be deductible.
The original cost will be considered $0 for any asset that has been placed in service for the later of 10 years or its depreciable life.
For example, a building purchased in 1990 may be subject to a 39 year depreciation schedule, so 2.5% of the original depreciation basis in the building can be used for 39 years to allow Section 199A deductions.
1031 Property Exchanges
Subsection 199A(h) gives the IRS the ability to create anti-abuse rules. Subsection (1) of this Section prevents the manipulation of depreciable periods, and Subsection (2) creates regulations for determining the unadjusted basis in Qualified Property acquired in like-kind exchanges or involuntary conversions.
A 1031 exchange occurs when either (1) one property is exchanged for another, or (2) a property is sold, with the sales proceeds being escrowed and then used to purchase a replacement property while following the deferred exchange rules. The property that is sold tax free in a 1031 exchange is called the relinquished property, and the property that is acquired in exchange for the relinquished property is the replacement property.
The Section 199A regulations provide that the acquisition basis and holding period relate back to the relinquished property, as if it was never exchanged. As a result of this, taxpayers who are selling real estate may reconsider whether they want to engage in a 1031 exchange, given that the replacement property cannot be used in the 2.5% qualified property calculation once it has been fully depreciated.
Many taxpayers don’t realize that they would be better off paying the 15% or 20% capital gains tax on the sale of real estate, and then receiving large depreciation deductions that can reduce ordinary income over time that would otherwise be taxed at a 37%. In addition, much of this can be written off in the year of acquisition by using what is called component depreciation, which often allows an immediate deduction for components and operating systems of a building, such as the air conditioning, heating, plumbing and electrical systems.
Taxpayers who are involved in the real estate industry should be generally aware of the above issues, and also seek direct advice from whoever will prepare their tax returns and possibly other tax advisors. This is too complicated to be handled without expert advice.
You can email me at email@example.com for our white paper on Section 199A.