The Tax Cuts and Jobs Act includes a 20 percent deduction for pass-through income to help small businesses and job creators. While corporations will now benefit from a flat 21 percent tax rate, this new 20 percent deduction against qualified business income reportedly was intended to bring similar benefits to small businesses including many real estate sole proprietors and small firms structured as pass-through entities.
This 20 percent deduction, however, also potentially benefits real estate investors at all income levels. The resulting tax break may be available to everyone with investment real estate including landlords with modest holdings as well as multimillion-dollar investors.
This deduction is complicated, so it is best to first walk through the basics.
What is pass-through income?
Pass-through income is business income that is taxed at the individual tax rates of the business owner rather than at corporate rates. Business income that passes through to an individual from a pass-through entity or income from a sole proprietorship will be taxed at individual tax rates with a deduction of up to 20 percent under the new tax code to effectively bring the tax rate down.
What are pass-through entities?
A pass-through entity is a business structure that is used to reduce the effects of double taxation. Pass-through entities don’t pay income taxes at the corporate level. Instead, the income is allocated among the owners, and income taxes are only levied at the individual owners’ levels. Partnerships, many LLCs and S corporations are pass-through entities for federal income tax purposes. This means that pass-through entities pay no business income tax. Rather, the owners are directly taxed individually on the income, taking into account their share of the profits and losses.
What are some examples of business structures and their tax treatment?
-
Sole proprietorship: Taxpayers do not file a separate tax return. Instead, their business income and expenses are reported on a federal form 1040, Schedule C.
-
Partnership: An association of two or more persons to carry on a business, which files a separate form 1065. Income and losses are passed to the individual partners who report that information on their individual tax returns.
-
Limited Liability Company (LLC): A popular hybrid entity with liability protection similar to a corporation when formalities are observed, and the option to be taxed as a partnership, which is a pass-through entity, or a corporation.
-
Single Member Limited Liability Company: An LLC with a single member is often treated like a sole proprietorship for federal tax purposes. There’s no separate tax form, and income and expenses are reported on a Schedule C, just as with a sole proprietorship.
-
C corporation: Files a federal form 1120 and pays any tax due. Shareholders also pay tax at their individual income tax rates for dividends or other distributions, and thus there is “double taxation.”
-
S Corporation: A corporation with tax treatment similar to a partnership. An S corporation files a federal form 1120-S, which passes most items of income or loss to shareholders who are responsible for reporting that information on their individual tax returns.
How does a business or property owner decide which business model to use?
This is a decision to be made together with legal and tax counsel after a review of applicable state and federal laws. It also helps to keep in mind that the legal structure will not necessarily match the tax treatment, for example, a company organized as a C corporation may be taxed as a pass-through S corporation. Entity choice may be based on a variety of considerations including liability, control and taxes.
What is the new 20 percent deduction?
The Tax Cuts and Jobs Act contains a deduction for qualified business income that is taken “above the line.” In other words, the taxpayer does not have to itemize deductions to take this 20 percent deduction, but there are conditions. The act limits the 20 percent deduction to non-personal service businesses.
What is a specified service trade or business, or a personal service business?
A specified service trade or business is any business involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services, or “any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners.” The definition also includes a business where the performance of services consists of investing and investment management trading, or dealing in securities, partnership interests or commodities. This definition would not apply to real estate investors because their principal asset is their property. On the other hand, most real estate agents and brokers will be considered to be in a specified personal service business and thus would not qualify for the 20 percent deduction. But there are exceptions.
What is the personal service income exception?
The National Association of REALTORS® was able to help secure a major exception referred to as the personal service income exception. This will make it possible for many real estate professionals to be able to take advantage of the deduction.
This exception provides that if the business owner has taxable income of less than the $157,500 threshold for single taxpayers or the $315,000 threshold for couples filing jointly, then the personal service restriction will not apply. Independent contractors and pass-through business owners with personal service income, including real estate agents and brokers, with taxable income below the $157,500 or $315,000 thresholds, respectively, may generally claim the full 20 percent deduction under the personal service income exception.
Independent contractors and pass-through business owners with nonpersonal service income and total taxable income below the thresholds may also claim the full 20 percent qualified business income deduction.
Does an independent contractor need to have a pass-through entity to use the 20 percent deduction?
No, as is illustrated in the situation of Amy Agent. Amy is single and for 2018 has $55,000 in commission income net of her normal business expenses. Amy has no dependent children and claims the standard deduction.
Under the prior law, Amy would pay ordinary income tax rates on her net commission income. She would deduct the $4,150 personal exemption and the $6,500 standard deduction, resulting in $44,350 in taxable income and a tax of $6,741 based on the 25 percent marginal tax rate bracket.
If the new tax law is applied to those numbers, Amy would receive a 20 percent deduction for her net commission income. She is below the threshold income level and benefits from the personal service income exception. This deduction reduces Amy's taxable income by $11,000, or $55,000 multiplied by 20 percent. She also takes the standard deduction of $12,000 for a taxable income of $32,000 and a tax of $3,650.
The new 20 percent deduction saves Amy $1,320, or $11,000 multiplied by 12 percent, since she is in the 12 percent marginal tax bracket. Amy’s total tax reduction is $3,091.
This scenario is a summary of an example discussed in NAR’s “The Tax Cuts and Jobs Act — What it Means for Homeowners and Real Estate Professionals.”
Can the 20 percent deduction still be used by real estate professionals if the income thresholds are exceeded?
Above the threshold level of income, the benefit of the 20 percent deduction for real estate brokers and agents is phased out over an income range of $50,000 for singles and an income range of $100,000 for couples. The benefit of the 20 percent deduction decreases as income increases. The deduction is fully phased out for single individuals who have an income above $207,500 and for married couples filing joint returns when their income exceeds $415,000.
Take the situation of Barry Broker, the sole owner of BB Properties LLC, which is taxed as a partnership. He has no dependents and claims the standard deduction. For 2018, Barry has net business income of $175,000 from his real estate brokerage business.
Under prior law, Barry would pay tax on his net brokerage income. He would take the $4,150 personal exemption and the $6,500 standard deduction for taxable income of $164,350 and a tax of $38,861 computed at the 28 percent marginal tax bracket.
Under the new law, Barry’s taxable income is higher than the $157,500 threshold for single individuals, but not higher than the $207,500 upper limit of the phase-out range. Thus, Barry must compute a prorated deduction.
The 20 percent deduction for Barry will be computed as follows: Barry deducts the new standard deduction of $12,000 from his $175,000 income for taxable income of $163,000. Next he subtracts the $157,500 income threshold for singles, which equals $5,500. This is divided by $50,000, representing the phase-out range; this results in 11 percent, which is the percentage amount of deduction disallowed. This generates a $31,150 deduction. Barry deducts this amount and the new $12,000 standard deduction from his $175,000 brokerage income to arrive at $131,850 in taxable income and a tax of $25,934 computed in the 24 percent marginal tax bracket.
The deduction saves Barry $7,476, and his total tax reduction would be $12,927.
This scenario is another summary of an example discussed in NAR’s “The Tax Cuts and Jobs Act — What it Means for Homeowners and Real Estate Professionals.”
Can the 20 percent deduction still be used by real estate investors if the income thresholds are exceeded?
Yes, subject to the wage and capital limit exception for businesses whose owners have nonpersonal service income above the income thresholds. The wage and capital limit exception places a limit on the 20 percent deduction equal to the greater of (a) 50 percent of the W-2 wages paid by the business, or (b) the total of 25 percent of the W-2 wages paid by the business plus 2.5 percent of the cost basis of the tangible depreciable property of the business, excluding land, at the end of the year. There are those who say this was created for real estate developers who have comparatively few employees paid relative to their capital investment or the income they generate. Other businesses such as manufacturing or construction may similarly benefit under this exception along with real estate investors who have net income from property.
This means that a pass-through entity that pays a large amount in employee wages would be able to take a larger deduction than one that has a smaller payroll. Capital-intensive businesses like real estate may also benefit if they have significant depreciable property assets.
See the example for David Developer discussed in NAR’s “The Tax Cuts and Jobs Act — What it Means for Homeowners and Real Estate Professionals.”
This article obviously only addresses the basic principles and is not legal or tax advice. The new rules for the 20 percent deduction are complicated and could be modified by subsequent legislation or clarified through guidance by the Treasury Department and the IRS. These new rules are not entirely clear; the deeper one goes into the details and applicability, and may depend on if the business is a sole proprietorship, LLC, S corporation or some other business entity. For instance, it is said to not be entirely clear whether people who own real estate in their own names and file their rental income on Schedule E would qualify for the pass-through deduction. At the same time, reclassification of the business model may lower the tax bill for some businesses. Firms should consult with their tax and legal advisors on how to proceed with future tax filings and their business classification. As always, individuals should consult a tax professional about their own personal situation.
Resources
Debbi Conrad is Senior Attorney and Director of Legal Affairs for the WRA.