IRS Code Section 199A: How the New 20% Pass-Through Deduction Affects Investors
Wondering how the new The Tax Cuts and Jobs Act Section 199A regulations will affect you and your investments? Let’s take a deep dive into the newly released final regulations surrounding the 20% pass-through deduction, including:
- What IRS Section 199A is and who exactly it applies to
- Who is excluded from deductions laid out under Section 199A
- How the 20% pass-through deduction affects real estate investments
- Revenue Procedure 2019-7, a new release that provides a Safe Harbor for certain rental activity
- Information you can take to your CPA to better understand how your taxes are affected
- Important advice regarding why you might need form 1099s
At the end of 2017, Congress passed The Tax Cuts and Jobs Act, which was a sweeping tax reform bill, one of the largest I’ve ever seen.
One of the many changes was a new tax break meant for business owners operating as a sole proprietor or through a pass-through entity such as an LLC or S corporation. This tax break allows certain taxpayers to deduct 20% of the net qualified business income (QBI) for purposes of calculating their taxable income.
The question many CPAs and real estate investors asked was, “Will my rental real estate income count as QBI for the purposes of this 20% deduction?”
On January 18th, 2019, the IRS released final regulations on Section 199A, giving us our long-awaited answer.
What is the IRS Code Section 199A Pass-Through Deduction?
Section 199A allows business owners to take a tax deduction on their QBI.
Per IRC Sec 199A(c), QBI means, for any taxable year, the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer. This income must be effectively connected with the conduct of a trade or business within the United States, and there are exceptions to the types of income that qualify [see IRC Sec 199A(c)(3)(B)].
The term “qualified trade or business” means any trade or business other than a specified service trade or business (SSTB), or the trade or business of performing services as an employee.
If you are single and your taxable income is below $157,500 ($315,000 if married), you’ll qualify for the full 20% deduction on your QBI even if you are running an SSTB. It’s important to note that these thresholds are regarding taxable income, which takes into account your standard or itemized deductions.
There is a phase-out of the 20% deduction after your taxable income increases above those two thresholds.
Once your taxable income exceeds $207,000 ($415,000 if married), the 20% deduction will be completely phased out for SSTB owners, and all other business owners will be subject to a limitation calculation to determine their QBI deduction.
The limitation calculation is the lesser of 20% of QBI and the greater of:
- 50% of the taxpayer’s share of the W-2 wages with respect to the qualified trade or business, or
- 25% of the taxpayer’s share of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the taxpayer’s share of the unadjusted basis of the qualified property immediately after acquisition.
For example, Joe is single and has taxable income of $240,000 and QBI income from his qualified business of $300,000. Joe owns 100% of the business and paid $100,000 in W-2 wages through the course of his business. Because Joe’s taxable income is above $207,000, Joe is subject to the limitation calculation, and his QBI deduction is calculated as follows:
The lesser of:
- 20% of QBI = $60,000
- The greater of:
- 50% of W-2 wages paid = $50,000
- 25% of W-2 wages paid ($25,000) + 2.5% of the unadjusted basis of property ($0) = $25,000
The greater of sub-items #1 and #2 is $50,000. The lesser of #1 ($60,000) and #2 ($50,000) is $50,000. Thus, Joe’s QBI deduction would be $50,000.
What Are SSTBs as Related to Section 199A?
A specified service trade or business (SSTB) is not considered a qualified business under Section 199A. This means that income generated by SSTBs will not be allowed a QBI deduction once the owner’s taxable income exceeds $207,000 ($415,000 if married).
The final regulations provided clarity as to what SSTBs are and are not within each of the following fields: health, accounting and law, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, and dealing/trading. If you are running a business that falls into these categories, I recommend getting with your CPA and combing through the final regulations starting on page 73 to determine if your facts and circumstances make your business an SSTB.
Important for readers of BiggerPockets is that “brokerage services” relates to the trading of financial securities, so real estate brokers and agents will not be considered SSTBs. Additionally, real estate developers and property managers are not considered SSTBs.
How Does Section 199A Apply to Rental Real Estate?
I’ve explained what the QBI deduction is and how/when it applies to SSTBs and business owners. But what about rental real estate?
Before the final regulations dropped, there was confusion as to whether rental real estate would qualify for the QBI deduction. The source of the confusion was in determining how rental real estate activities could rise to the level of a “trade or business” under Section 162. If rental activities could be classified as Section 162 trades or businesses, the income produced by such activities would qualify for the QBI deduction under Section 199A.
The problem is that the analysis of whether or not rentals qualify for a Section 162 trade or business is challenging due to murky regulations and case law. We needed (hoped) for some form of a bright line test to tell us whether rentals would qualify as a trade or business and thus allow us to use the QBI deduction against net rental income.
Revenue Procedure 2019-7: A Safe Harbor
Along with releasing the final regulations on Section 199A, the IRS also released Revenue Procedure 2019-7. This Revenue Procedure provides a Safe Harbor that allows a rental activity to rise to the level of a Section 162 trade or business if:
- Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise;
- 250 or more hours of rental services are performed per year with respect to the rental enterprise; and
- The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, regarding the following: (i) hours of all services performed; (ii) description of all services performed; (iii) dates on which such services were performed; and (iv) who performed the services. This requirement will not apply to taxable years beginning prior to January 1, 2019.
For item #1, a “rental real estate enterprise” is an interest in property held for the production of rents. An individual or a relevant pass-through entity (RPE) must hold the interest in property directly or through a disregarded entity. An RPE is a partnership or an S corporation that is owned, directly or indirectly, by at least one individual, estate, or trust.
For item #2, “rental services” includes:
- Advertising to rent or lease the real estate;
- Negotiating and executing leases;
- Verifying information contained in prospective tenant applications;
- Collection of rent;
- Daily operation, maintenance, and repair of the property;
- Management of the real estate;
- Purchase of materials; and
- Supervision of employees and independent contractors.
Rental services may be performed by owners or by employees, agents, and/or independent contractors of the owners. The term “rental services” does not include financial or investment management activities, such as:
- Arranging financing;
- Procuring property;
- Studying and reviewing financial statements or reports on operations;
- Planning, managing, or constructing long-term capital improvements; or
- Hours spent traveling to and from the real estate.
Exclusions From the Safe Harbor
Unfortunately, certain forms of real estate investing are excluded from using this safe harbor. For instance, any property in which you rent and also use as a personal residence for more than 14 days per year cannot qualify for this safe harbor. Additionally, any property rented under a triple net lease (NNN) will not qualify. That is bad news for many BiggerPockets investors.
If your rental activity qualifies for the Safe Harbor under Revenue Procedure 2019-7, the income will be considered QBI and will qualify for the pass-through deduction.
What if My Rentals Don’t Qualify for the Safe Harbor?
It’s important to note that if your rental activity does not meet the criteria for the Safe Harbor under Revenue Procedure 2019-7, you may still be able to take a QBI deduction by qualifying as a trade or business under Section 162.
It is difficult to know whether your rental activities qualify as a trade or business under Section 162. There are no uniform standards, and the determination of whether a landlord’s rentals qualify as a trade or business is made on a case-by-case basis. That’s why this safe harbor is so great for landlords and their CPAs—it provides bright lines needed to make a determination.
Interpreting Safe Harbor Regulations Related to Real Estate Investments
Regardless, if you can’t use the Safe Harbor, you’ll have to resort to interpreting complex and confusing case law in determining whether your rental real estate activities rise to the level of a Section 162 trade or business.
The Supreme Court held in Commissioner v. Groetzinger that, “We accept the fact that to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit.” However, this is a broad standard and left lower courts struggling to interpret the ruling.
In an attempt to shed light on the matter, the IRS discussed the concept of a rental trade or business in Private Letter Ruling 9840026: “The issue of whether the rental of property is a trade or business of a taxpayer is ultimately one of fact in which the scope of a taxpayer’s activities, either personally or through agents, in connection with the property, are so extensive as to rise to the stature of a trade or business.”
Qualifying as a Real Estate Professional Doesn’t Cut it
Many landlords and their advisors then thought that qualifying as a real estate professional would allow their rental activities to rise to the level of a trade or business. However, courts have held that qualifying as a real estate professional merely allows one to overcome the presumption that their rental activities are not passive. This means that simply qualifying as a real estate professional will not allow you to claim that your rental activities rise to the level of a trade or business.
The above is not meant to be an in-depth discussion on how to qualify your rental real estate activities. It is intended to provide you with high-level information that you can take to your CPA to start a dialogue.
Watch Out for the Requirement to Issue Form 1099s
So you’ve gone through Section 199A and determined that your rentals either qualify for the safe harbor or rise to the level of a trade or business. This means that they qualify for the QBI deduction and you’ll enjoy sweet tax savings as a result.
Just make sure your tax savings don’t get wiped out by penalties for not issuing Form 1099s.
What’s that? You didn’t know of this requirement? Of course not, because landlords aren’t necessarily required to issue Form 1099s for their passive activities.
But taxpayers engaged in a trade or business are required to issue Form 1099s. So if you are claiming that your rental real estate activities rise to the level of a trade or business, you’ll have to issue Form 1099s for payments you’ve made throughout the year.
If your rental activities rise to the level of a trade or business, the only time you don’t need to issue a Form 1099 to a vendor is when the payment was made to another business that is incorporated, but was not for medical or legal services or the sum of all payments made to the person or unincorporated business is less than $600 in one tax year.
In order to collect the information you need to issue a Form 1099, you should request a Form W-9 from the vendor. We encourage our clients to require a Form W-9 be provided to them by the vendor before any work starts on a rental property. This includes contractors, property managers, and even your CPA!
Summary: Speak With Your CPA Regarding Section 1099A Rules
What a load of information. The good news is that much clarity was provided with the issuance of final regulations for Section 199A. A Safe Harbor was provided for landlords via Revenue Procedure 2019-7 that provide bright-line tests for qualifying your rental activities as a trade or business.
The bad news is that the 250-hour requirement of the Safe Harbor may be tough for some small landlords to meet. Additionally, investors leasing on a triple net basis seemed to have gotten the worst of it all.
Speak with your CPA and get a plan in place for 2019. There are many strategies that you can now confidently tap into in order to make the Section 199A rules work in your favor.
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Any questions about IRS Code Section 1099A or the 20% pass-through deduction? Does this bode well for your investments?
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