One of the big windfalls for real estate investors and professionals in the 2017 Tax Cuts and Jobs Act is the opportunity to take up to a 20 percent deduction of income from pass-through entities. Initially, the deduction generated a lot of excitement. But some of the uncertainty clouding the picture may be taking some of the wind out of the sales of that enthusiasm.
Investors are finding plenty of fine print to wade through in terms of eligibility requirements and limitations as it relates to the type of income and type of business. To that point, the IRS recently released a notice that includes proposed safe harbor rules to help identify rental real estate that qualifies for the Section 199A deduction. “There are certainly limitations, but it is still a big deal for people who are structured as either a sole proprietorship or a pass-through entity,” says Brian Newman, CPA, partner and office department head at accounting firm CohnReznick.
Pass-through entities include partnerships, such as LPs and LLCs, as well as S-corps and sole proprietorships. For those who own a stake in those entities, the deduction applies specifically to a deduction on qualified business income (QBI) from the pass-through to arrive at taxable income. For taxpayers in the top federal tax bracket of 37 percent that qualify for the full deduction, it could effectively reduce their tax rate to 29.6 percent on this category of income.
“It is a very generous benefit for operating a business in pass-through form,” says Stephen M. Sharkey, a partner in the law firm of DLA Piper in Baltimore. Sharkey’s practice focuses on the federal and state tax aspects of real estate transactions and investments. To a certain extent, the pass-through deduction tries to create some parity between pass-through entities and corporations, which saw a big tax rate drop from 35 percent to 21 percent, he adds.
Clear winners jump out
One group that is popping champagne corks to celebrate access to the full 20 percent is REIT investors. REIT dividend income that is taxed at ordinary rates receives the full 20 percent deduction, with no limitation. This also includes both publicly-traded and non-listed REITs.
For everyone else involved in rental real estate investment, the outcome of the potential tax break on pass-through income is a lot more complicated, sometimes making it difficult to determine eligibility. “Rental income has been one of those things that has been a little tricky in respect to the Section 199A business deduction,” says George Kotridis, CPA, a principal, real estate, at CliftonLarsonAllen LLP in Plymouth Meeting, Pa.
The key point is that the IRS wants to qualify this deduction for QBI and not other types of income. Essentially, the IRS was trying to weed out some of the more passive investors and focus on the original intent of the tax reform act, which was creating deductions for individuals or businesses that would result in job growth and business or real estate reinvestment. “The crux of what this tax reform is really about is providing a benefit to business, but more so to businesses that invest in people and wages and invest in assets,” says Kotridis.
A second group that does get a bit of a break is taxpayers who are under the cap for personal income ($315,000 for married couples filing jointly and $157,500 for individuals). They are eligible to take the full 20 percent deduction if they receive QBI for their rental property. Although that rental income would still have to come from an approved trade or business, the benefit for those with lower incomes is that they do not have to deal with further restrictions on W2s or an adjusted basis on the property. Effectively, it is easier for them to realize the full 20 percent deduction.
Higher incomes face more hurdles
The IRS notice was aimed at clarifying uncertainty related to who is—or isn’t—eligible for the breaks. Specific to rental real estate, safe harbor is given to those enterprises that spend 250 hours or more per year providing services for a property or portfolio of properties.
However, the IRS specifically excluded triple net lease properties from that 250-hour safe harbor. That exclusion speaks to the point that the IRS is again drawing a line between QBI and other income. “You have to be doing a lot more than just collecting a rent check every month,” says Newman. Although that is a concern for pass-throughs that own triple net lease properties or ground leases, the IRS also left the door open for those pass-through business interests to alternatively qualify if they are recognized as a trade or business.
It is important to note that the safe harbor is not the only way to qualify for the 20 percent QBI deduction. Pass-throughs involving rental real estate that are recognized as a trade or business (technically, qualifying as a section 162 trade or business), would be eligible for the 20 percent deduction. Here is where things get complicated. Apparently, there is a lot of gray area in the rental real estate world in terms of being officially recognized as a trade or business. A hotel would be an obvious example, because it includes an operating business. For someone who owns the ground lease under that hotel and simply receives a rent check each month, it is much more difficult to qualify.
“Unfortunately, there is no bright line test. So, it is very difficult in the real estate world to make a determination as to whether someone is in a trade or business or not,” says Newman. The best way to rise to trade or business status is to show regular and continuous activity in operations. Typically, in triple net leases that is not happening, but in some cases, triple net lease investors are more actively involved in operations, adds Newman.
Once eligibility is established for those individuals above the income threshold (again, $315,000 for married couples and $157,500 for individuals), there is a higher “phase out” level and more limitations that come into play. And here is where it is especially important to have a good accountant or tax advisor. Individuals would have to identify net income from the eligible business and compare it against threshold W2 amounts and unadjusted depreciable basis of property to come up with the amount of QBI and the percentage they are eligible to deduct.
It is likely that there will be some lingering uncertainty as the tax laws gets put to the test in 2019. So while the recent notice does provide additional guidance, the IRS could provide more clarity as to the definition of QBI, adds Kotridis.