IRS Code Section 199A: How the New 20% Pass-Through Deduction Affects Investors

by | BiggerPockets.com

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:

  1. 20% of QBI = $60,000
  2. The greater of:
    1. 50% of W-2 wages paid = $50,000
    2. 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.

irs-code-199a

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.

Related: How to Gift Properties to Your Family (Not the IRS)

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:

  1. Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise;
  2. 250 or more hours of rental services are performed per year with respect to the rental enterprise; and
  3. 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.

Related: The Latest Tax Reform Update and What It Means for Real Estate Investors

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.

20-passthrough-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.

Disclaimer: This article does not constitute legal advice. As always, consult your CPA or accountant before implementing any tax strategies to ensure that these methods fit with your particular situation.

Any questions about IRS Code Section 1099A or the 20% pass-through deduction? Does this bode well for your investments?

Weigh in with a comment!

About Author

Brandon Hall

Brandon Hall is a CPA and owner of The Real Estate CPA. Brandon assists investors with Tax Strategy through customized planning and Virtual Workshops. Brandon is an active real estate investor and a Principal at Naked Capital, a capital group investing in large multi-family projects and manufactured housing. Brandon's Big 4 and personal investing experiences allow him to provide unique advice to each of his clients.

51 Comments

  1. Christopher Smith

    I have a question.

    I can easily record my own time as applied to the 250 hour safe harbor threshold, but how do I determine the time spent by my property manager/agents, and by derivation the contractors they retain to work on my properties?

    I think it very unlikely that they could (or would) keep a time log for my individual rental activities. Could a $/hour rate be established and then applied to the dollars I pay for their services to back into a reasonable time estimation?

  2. Joe J.

    “250 or more hours of rental services are performed per year with respect to the rental enterprise”

    Does this mean 250 or more hours of service by the taxpayer him/herself, or can it include contractors hired by the taxpayer to perform maintenance, etc.?

  3. Steve T.

    Hi Brandon,

    If an investor meets the QBI rules and takes advantage of the 20% reduction, will rental income be considered business income? If so, would the remaining rental income (after the 20% reduction) be subject to the additional self-employment tax at at 15.3%?

    I am hoping I am missing something, because this would obviously be problematic.

    • Brandon Hall

      Rental income is considered passive income which is not subject to SE (15.3%) taxes. Even if your activities rise to the level of a trade or business, and even if the rental income is considered to be non-passive, that doesn’t mean your rental income will be subject to SE income.

  4. Rick harmon

    So does the 750 hours to qualify as a Real Estate Investor no longer count? I only have 2 single family homes but this year I plan on expanding. I can get the 750 looking, learning and rehabbing and the such but not 250 just watching my 2 rentals, I would need a lot more rentals, Like Big Brandon said, he only spends about 3 hours a week looking over his 50+ units. So 750 out and 250 in?? Just like the IRS to clarify by not clarifying.

    Thank you

  5. Anthony Conte

    Another article which shows landlords

    https://www.forbes.com/sites/alangassman/2018/11/01/does-rental-income-qualify-for-the-new-20-section-199a-deduction/#51b5a6f6a6ac

    The court cases interpreting Section 162 have not always been kind to landlords. In particular, there needs to be something more than a long-term triple net lease where a landlord just collects rent and does very little else in order to qualify as being a trade or business.
    A landlord that provides active management relating to a particular building, or at least administers common area expenses, should probably be able to take the Section 199A deduction.

    Imo
    Based on these articles which talk about court judgements, as long as you are active, even with a hired manager, you should fall under section 162.
    At least that’s what I gather from what I have read.

  6. Timothy Arn

    Hello Brandon, Great article!
    Looking over the example of ‘Joe’ provided… it appears to me that if a business has no W-2 wages paid that it completely eliminates the QBI deduction, as that would be the lesser of the two. Am I inferring correctly?
    Or…is this example of ‘Joe’ only for a taxpayer who has exceeded the $207,000 threshold?
    Thanks for your clarifying this.

    • Brandon Hall

      Joe’s taxable income was $240k, thus he was subject to the limitation calc. Because he paid $100k in wages, his limitation QBI calc is $50k (50% of W2 wages). That’s less than 20% of his QBI ($60k), so his deduction is $50k.

  7. Krystal Le

    Hi Brandon,

    Thank you for the informative and timely article. My questions would be regarding the commonly controlled ownership where one owner owns at least 50% of both a business and a rental company (LLC). The owner will then lease the property back to his other business under a triple net lease. I am confused whether he will be able to get 20% deduction on the income from rental company. My understanding is that

    1. If the main business is SSTB & his taxable income is under the threshold => he qualifies for 20% deductions.
    2. If the main business is SSTB & his taxable income is over the threshold => he DOES NOT qualifies for 20% deductions.
    3. If the main business is NOT SSTB, he qualifies for 20% deductions.

    I would appreciate if you could give me your thoughts.

    Thank you,

  8. Andrew P.

    Say I make 75K at my W2 job and 70K in annual gross rent. Give or take about (rough estimate) 50K for deductions like interest, property taxes, repairs, contractors, utilities, etc. Does that mean the 20% deduction applies to 20K (70K rental income-50K deductions) and thus gives me another 4K in deductions OR does it apply to the annual gross rent before I take the deduction and giving me a better 14K in deduction?

  9. Teresia Sayler

    Hi Brandon,
    A question above was about issuing 1099 for the year 2018. You mentioned at the beginning of your article that part of qualifying (condition number three) was that these would be required starting 2019. Does that mean we should go ahead and issue them for 2018, or there is no requirement, therefore, we can still experience the 20% pass through without them if we qualify otherwise for the tax year 2018?

  10. Mark Haney

    Hi Brandon, thanks for another excellent article, clearly explaining some of the new intricacies in the tax law.

    This might be a simple question – but if my primary real estate LLC is a 50/50 partnership, do we both just get 50% of the 20% deduction? If I let my CPA know that I believe we meet the Safe Harbor requirements you’ve described as an LLC, will this deduction be reflected on each of our K-1s and there is nothing additional to do differently on our personal returns?

    Thank you so much for sharing your expertise!

  11. Rhonda Wilson

    I have three different property management companies working for me on four different properties. I’m balking at asking them to create a log of hours worked. I’m pretty sure that I could come up with a summation of full time equivalent workers, however, if I asked for it. For example, I have 20% of person A, 5% of person B, 10% of person C, etc. A full time person is 2080 hours per year. Could I multiply the sum of the percentages times 2080 hours to come up with a total? It should be above 1000 hours.

  12. Nicole Dunlap

    “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.”

    If I have a 3 family home but live in one of the units as my primary residence, do I no longer qualify for Safe Harbor (its one tax parcel but multiple residences)? Even if I keep seperate income/expense accounts for the other units and have 250 hours of activity for the year (basically qualify in all the other ways mandated)? I definetly purchased it “for the purpose of making profit/income.”

    • Brandon Hall

      If the units have separate mailing addresses (i.e. 123 Main St, Unit A) then I’d break the three units out on Sch E (i.e. 123 Main St Units A-C) or list each unit separately on Sch E. The latter is not ideal but gets it done.

  13. gary li

    Hi Brandon, I have a question about the 20% deduction, I have full time job with W-2 income over $20700 single, and I manage my Rental property by myself for net Rental income $30K. so how to calculate my 20% deduction? Thanks

  14. gary li

    Hi Brandon, Thank you for answer my question!
    My W-2 wages is nothing to do with the Rental Business, it is for my full time IT job.
    My net Rental Income $30K is all passive income from the Rent, there is no W-2 wages from the Rental Business.
    What is the unadjusted Basis of the rental? how to calculate the deduction? I appreciate your help.

  15. Tim Carlson

    Apologies if this has already been answered and I didn’t search on the right terms. 🙂

    For rental properties, does the deduction still apply if one owns the properties directly (rather than via an LLC or other entity) and simply reports them on Schedule E?

    Thanks,

    Tim

  16. Donald Chase

    If a person has multiple properties, each in its own LLC and with separate entries on Schedule E, and a contractor works on each of the properties during the year, is the $600 amount for issuing a 1099 to this contractor based on the separate work on each property or summation of the work on all properties? Thank you for your insight and willingness to help the community.

  17. Teresia Sayler

    On the topic of gather W-9’s in order to issue 1099’s… did I understand correctly that you do not need to collect a W-9 or issue a 1099 to an incorporated business/contractor? Or would safe/best practice be to gather W-9’s and issue 1099 on EVERYONE paid more than $600/yr?

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