The New 20% Pass-Through Deduction and You

87 Replies

The IRS issued more guidance on Wed, Aug 8th on the new Sec. 199A 20% pass-through deduction. But many taxpayers are wondering does this apply to real estate activities as well.

The 20% deduction applies to Qualified Business Income (QBI) from a "trade of business." Capital gains, interest income, and dividends (except from a REIT or PTP) are explicitly not included. The proposed regs are silent as to whether a rental activity is a "trade or business" but instead relies on Sec 162. Sec 163(j)(7)(A) is pretty clear that rental income does not qualify as income from a trade or business, so for purposes of the 20% deduction my guess is it's not likely to qualify either. This also likely includes those who qualify for real estate professional treatment on their taxes (i.e. those with 750+ hours of substantial involvement in real estate).

However, there are a couple areas that may apply to those involved in real estate. The CFR 1.199A mentions:

  • “Both active and passive owners of a trade or business may be entitled to a section 199A deduction”
  • “The proposed regulations extend the definition of trade or business for purposes of section 199A beyond section 162 in one circumstance. Solely for purposes of section 199A, the rental or licensing of tangible or intangible property to a related trade or business is treated as a trade or business if the rental or licensing and the other trade or business are commonly controlled…”

So what likely qualifies?

  1. Management companies – Sometimes taxpayers with lots of rentals consider forming a separate management company. Rentals pay management fees to the management company, which operates as a normal trade or business.
  2. Some operators – Depending on the structure of a real estate syndicate, if the operator receives a management fee or guaranteed payment, then the operator would have Qualified Business Income (QBI) for taking the 20% pass-through deduction. However, profits interest, carry, capital gains, and pass-through rental income do not qualify as QBI. Also, in these instances, if the operator was taxed as a partnership or S-Corp, then there would have to be an allocation to determine the applicable amount of QBI.
  3. Real estate used in a business/self-rentals – Often business owners hold real estate used by a business in a different entity and capitalize that holding entity through a self-rental agreement between the business and holding entity. Self-rentals are subject to unique rules on net rental income and losses, but there are provisions that allow for the activities to be aggregated. So a business owner would include net rental income from the holding entity with the QBI from the business in calculating their 20% deduction under the aggregation rules.
  4. “Box 1” passive investors – Passive investors who receive a K-1 with income in Box 1 “Ordinary business income (loss)” will have QBI.
  5. Realtors and other professionals – Definitely a trade or business. However, these individuals or businesses are considered Specified Service Trade or Businesses (SSTB) and QBI from a SSTB gets phased-out for high income taxpayers.

The rules are complex and there’s a lot not even mention. Taxpayers with foreign assets, multiple businesses, prior year Net Operating Losses, or reasonable officer compensation requirements have even more complex rules involved.

While the regs offered some guidance with regard to rentals, it only clarified that you can aggregate rental activities to that of an active trade or business. And rental income would qualify only if the property was rented to a a business owned by the same controlling entity which did qualify for the 199A deduction.

In short what this comes down to is something that the IRS has basically refused to issue clear guidance on historically: At what point does real estate activity raise to the level of a trade or business to comply with IRS Code section 162.

There have been tax cases which rule both directions and the Tax courts have repeatedly said that they will review the specific actions of that investor and determine if it's raised to the level of a trade or business.

What does this mean? If someone is a RE Professional will they qualify? It's much more likely- but definitely not a guarantee.

Additionally, someone who isn't a RE pro CAN operate at the level of a trade or business.

Example: Someone owns 5 rentals that they report on their schedule E. They are all managed by a property manager. 4 are out of state. ....He won't qualify for this deduction. Definitely not a trade or business.

Someone owns 5 rentals that are reported on their schedule E. He self manages them. Does all repairs. Interviews and selects tenants himself. Has a written formal business plan. A growth plan. Assesses his profit and business health regularly. Ect. To me...This is a trade or business. If it walks like a ducks, quacks like a duck...its a duck. Or maybe an-undersized goose.

But you get what I'm getting at.

Additionally, the initial draft of the section 199a did NOT include the second limitation calculation. It only related to the 50% of W2 Income. It was later added to incorporate a limit based on asset basis as well. Many tax attorneys are interpreting this to be indicate of the allowance of rental income as well.

Ultimately: It's a gray area. There was no definitive guidance given. However we do know that it applies to trade or business income. Now the name of the game is prove you're a business.

Originally posted by @Christopher Smith :

Time for the real estate industry to do a little lobbying before these regulations go final.

When they released a reg back in 2013 relating to RE as trade or business for an extra applicable tax the same issue came up. 


Everyone screwed for the IRS to clearly state what determined "trade or business" with regard to real estate activities- they didn't provide it then either. 

Ultimately I think we need to look back at the tax cases, letter rulings, and court response on the matter of when people have/haven't qualified. 

I think we generally already know the answer to that for most passive investors, you won't qualify. I think what is needed is to challenge the agency's overly restrictive interpretation of the statute.

Originally posted by @Natalie Kolodij :
Originally posted by @Christopher Smith:

Time for the real estate industry to do a little lobbying before these regulations go final.

When they released a reg back in 2013 relating to RE as trade or business for an extra applicable tax the same issue came up. 


Everyone screwed for the IRS to clearly state what determined "trade or business" with regard to real estate activities- they didn't provide it then either. 

Ultimately I think we need to look back at the tax cases, letter rulings, and court response on the matter of when people have/haven't qualified. 

 is their an upper limit on this.. say you make 500k or 750k or 1 mil taxable does this mean we get to write off 100k  150k 200k right off the top ???? or is there like a lot of these rules no help for high income real estate professionals.. 

@Jay Hinrichs of course there are limitations! Quit doing so well in your business, gosh. 

Here is a great article where he goes through the nuts and bolts of here. 

https://www.forbes.com/sites/anthonynitti/2018/08/09/irs-provides-guidance-on-20-pass-through-deduction-but-questions-remain/#6b2122a92ff8

Originally posted by @Natalie Kolodij :

@Jay Hinrichs of course there are limitations! Quit doing so well in your business, gosh. 

Here is a great article where he goes through the nuts and bolts of here. 

https://www.forbes.com/sites/anthonynitti/2018/08/09/irs-provides-guidance-on-20-pass-through-deduction-but-questions-remain/#6b2122a92ff8

 ya I get all excited about this stuff then find out we don't qualify...  I don't know why people think these tax breaks go from bottom to top earners it seems that they are bracketed..  and once you hit a threshold of making too much our don't get any benefit and you just have to pay your tax's as normal.. and of course every year is different.. one year your on top the next your not.

Originally posted by @Jay Hinrichs :

@Natalie Kolodij  many west coast Husband and wife real estate teams will not qualify for this  shoot.

Ya if it makes you feel better as a personal services business I'm getting screwed. 

Hey tax pros- learn all about this amazing deduction you can't use!!!

...Thanks. 

Originally posted by @Jay Hinrichs :
ya I get all excited about this stuff then find out we don't qualify...  I don't know why people think these tax breaks go from bottom to top earners it seems that they are bracketed..  and once you hit a threshold of making too much our don't get any benefit and you just have to pay your tax's as normal.. and of course every year is different.. one year your on top the next your not.

Looks like I will be paying higher mgt fees to my s-corp (I have the right to charge myself, but not the obligation) and I'll be charging my s-corp a heckofa lot more office rent then. It has a space in a building owned by LLC #2.

Wait. More tax deductions are the last thing I need, yet I get to move the pea under yet another shell if I want to.

So far it's 0 for 3 benefiting anyone that needs it.

And Jay, thank you for your service ;)  

Originally posted by @Natalie Kolodij :

While the regs offered some guidance with regard to rentals, it only clarified that you can aggregate rental activities to that of an active trade or business. And rental income would qualify only if the property was rented to a a business owned by the same controlling entity which did qualify for the 199A deduction.

In short what this comes down to is something that the IRS has basically refused to issue clear guidance on historically: At what point does real estate activity raise to the level of a trade or business to comply with IRS Code section 162.

There have been tax cases which rule both directions and the Tax courts have repeatedly said that they will review the specific actions of that investor and determine if it's raised to the level of a trade or business.

What does this mean? If someone is a RE Professional will they qualify? It's much more likely- but definitely not a guarantee.

Additionally, someone who isn't a RE pro CAN operate at the level of a trade or business.

Example: Someone owns 5 rentals that they report on their schedule E. They are all managed by a property manager. 4 are out of state. ....He won't qualify for this deduction. Definitely not a trade or business.

Someone owns 5 rentals that are reported on their schedule E. He self manages them. Does all repairs. Interviews and selects tenants himself. Has a written formal business plan. A growth plan. Assesses his profit and business health regularly. Ect. To me...This is a trade or business. If it walks like a ducks, quacks like a duck...its a duck. Or maybe an-undersized goose.

But you get what I'm getting at.

Additionally, the initial draft of the section 199a did NOT include the second limitation calculation. It only related to the 50% of W2 Income. It was later added to incorporate a limit based on asset basis as well. Many tax attorneys are interpreting this to be indicate of the allowance of rental income as well.

Ultimately: It's a gray area. There was no definitive guidance given. However we do know that it applies to trade or business income. Now the name of the game is prove you're a business.

Wouldn't it technically be a business legally if it is an LLC? Heck even a Sole Proprietorship or S-Corp should qualify. Too many people think a business is only something that is an LLC, and apparently the IRS feels the same way, despite it not being true. LLC's are merely one form of business entity. I have a Sole Proprietorship. Some of my rentals required a business license issue by the city. Just because I chose a SP over an LLC doesn't mean it's not a business.

Might I add also that this is another reason that equity markets win over cash flow markets. I made several hundred thousand this year and the year before that etc. tax free thanks to 1031 exchanges, capital gains exclusion, etc. Try doing that on several hundred thousand of cash flow. You can drive yourself nuts trying to find loopholes in tax laws for that taxable income. Also for me it's just a handful of SFH's. To make the same in cash flow I'd have to have 50-100 houses to manage in a cash flow market to make the same.

Originally posted by @Jack B. :

Wouldn't it technically be a business legally if it is an LLC? Heck even a Sole Proprietorship or S-Corp should qualify. Too many people think a business is only something that is an LLC, and apparently the IRS feels the same way, despite it not being true. LLC's are merely one form of business entity. I have a Sole Proprietorship. Some of my rentals required a business license issue by the city. Just because I chose a SP over an LLC doesn't mean it's not a business.

LLC has nothing to do with the "trade or business" definition. Section 199A (the 20% deduction) applies to all forms of business, including sole proprietorship. All of them have to pass the "trade or business" test, regardless of how they are organized. Holding renting properties, with or without LLCs, may or may not qualify, case by case.

@Michael is spot on. 

A business literally has nothing to do with having an entitiy. 

It's a level of actions and intent defined by IRC section 162. The issue however is they have never made clarity with how it specifically relates to rental income..which typically as it sits...is not trade or business ( that's why you don't pay SE tax on it)

Originally posted by @Natalie Kolodij :

@Michael is spot on. 

A business literally has nothing to do with having an entitiy. 

It's a level of actions and intent defined by IRC section 162. The issue however is they have never made clarity with how it specifically relates to rental income..which typically as it sits...is not trade or business ( that's why you don't pay SE tax on it)

Yes I know, my point was that an LLC is legally a business, so rental properties in an LLC should get the pass through. It is a business under the state, a corporation. Try explaining this to the people at Costco when you try to sign up for the Business Executive membership, that not all businesses are an LLC though. That's the whole reason I bring this up. I signed up last weekend and they demanded an LLC certificate. I had one when I owned a tech company, but I explained as a landlord I pay income taxes on a business, but it's not an LLC. I had to explain not all businesses are an LLC. Hence why I pointed out there are different structures for a business. In any case, they wouldn't let me sign up for the business membership because I didn't have an LLC. No matter how much I explained to the "supervisor" that I pay taxes on schedule E for my rentals, and some of them even require a city business rental license, but not an LLC. An LLC is merely ONE option for a business, and technically you should get the pass through if you operate your rentals in an LLC.

@Jack B. , equity markets look great when the market is up.  When down, not so much.  ;-)  And the crunch is coming soon.  I sold my ‘dogs’ as well.  

Originally posted by @Alan Grobmeier :

@Jack B., equity markets look great when the market is up.  When down, not so much.  ;-)  And the crunch is coming soon.  I sold my ‘dogs’ as well.  

Unless you 1031 into cash flow markets before a crash, and then have tons of cash to deploy when there is a down turn in equity markets. At least while building wealth. When you have a ton of money, it's time to stay in paid off cash flow markets for security. At that point keeping the money is the most important thing. 

Originally posted by @Jack B. :
Originally posted by @Natalie Kolodij:

@Michael is spot on. 

A business literally has nothing to do with having an entitiy. 

It's a level of actions and intent defined by IRC section 162. The issue however is they have never made clarity with how it specifically relates to rental income..which typically as it sits...is not trade or business ( that's why you don't pay SE tax on it)

Yes I know, my point was that an LLC is legally a business, so rental properties in an LLC should get the pass through. Try explaining this to the people at Costco when you try to sign up for the Business Executive membership, that not all businesses are an LLC. That's the whole reason I bring this up. I signed up last weekend and they demanded an LLC certificate. I explained as a landlord I pay income taxes on a business, but it's not an LLC. I had to explain not all businesses are an LLC. Hence why I pointed out there are different structures for a business. They themselves don't make it a business. In any case, they wouldn't let me sign up for the business membership because I didn't have an LLC. No matter how much I explained to the "supervisor" that I pay taxes on schedule E for my rentals, and some of them even require a city business rental license, but not an LLC. An LLC is merely ONE option for a business, and technically you should get the pass through if you operate your rentals in an LLC.

Unfortunately that's not how this works. 

They're just calling it a pass through deduction for simplicity. 

It's purpose was to level the playing field when C corps received 1 set, lower tax rate. 

So to take it fair to other pass though entities- they gave them a 20% deduction. 

However there are different TYPES of income generating in any type of entity. If it's not qualify rental income being generated in a LLC/Partnership/ S corp. It still won't qualify

It's the type of income generated in compliance  per Tax code section 162 that matters. Unfortunately you're over simplifying it and you can't just use your interpretation of what makes a pass through override actual IRS  tax code. 

Originally posted by @Natalie Kolodij :
Originally posted by @Jack B.:
Originally posted by @Natalie Kolodij:

@Michael is spot on. 

A business literally has nothing to do with having an entitiy. 

It's a level of actions and intent defined by IRC section 162. The issue however is they have never made clarity with how it specifically relates to rental income..which typically as it sits...is not trade or business ( that's why you don't pay SE tax on it)

Yes I know, my point was that an LLC is legally a business, so rental properties in an LLC should get the pass through. Try explaining this to the people at Costco when you try to sign up for the Business Executive membership, that not all businesses are an LLC. That's the whole reason I bring this up. I signed up last weekend and they demanded an LLC certificate. I explained as a landlord I pay income taxes on a business, but it's not an LLC. I had to explain not all businesses are an LLC. Hence why I pointed out there are different structures for a business. They themselves don't make it a business. In any case, they wouldn't let me sign up for the business membership because I didn't have an LLC. No matter how much I explained to the "supervisor" that I pay taxes on schedule E for my rentals, and some of them even require a city business rental license, but not an LLC. An LLC is merely ONE option for a business, and technically you should get the pass through if you operate your rentals in an LLC.

Unfortunately that's not how this works. 

They're just calling it a pass through deduction for simplicity. 

It's purpose was to level the playing field when C corps received 1 set, lower tax rate. 

So to take it fair to other pass though entities- they gave them a 20% deduction. 

However there are different TYPES of income generating in any type of entity. If it's not qualify rental income being generated in a LLC/Partnership/ S corp. It still won't qualify

It's the type of income generated in compliance  per Tax code section 162 that matters. Unfortunately you're over simplifying it and you can't just use your interpretation of what makes a pass through override actual IRS  tax code. 

lol, not over simplifying it, read on, this isn't the first tax attorney's blog I've read that states you CAN do this in an LLC or a SP, etc.

http://sctaxlawyers.net/the-new-20-pass-through-de...

https://www.nolo.com/legal-encyclopedia/how-the-re...

For landlords, the most stunningly good provision of the TCJA is a new tax deduction for owners of pass-through businesses. This includes the vast majority of residential landlords who own their rental property as sole proprietors (who individually own their properties), limited liability companies (LLCs), and partnerships. With these entities, any profit earned from the rental activity is “passed through” to the owner or owners’ individual tax returns and they pay tax on it at their individual income tax rates.

  • John owns a 20-unit residential apartment building through an LLC. The apartment building was constructed and furnished in 2012. The original cost of the land was $200,000, the building cost was $1,000,000 to construct, and the fixtures, furnishings and equipment in the building cost another $400,000. The building has a non-accelerated depreciable life of 39 years and the equipment has a useful life of 5 years. In 2018, the LLC has a taxable profit of $300,000. Initially, only the $1.4 million cost of the building and other personal property potentially qualifies; the land does not. The potential 20% pass-through deduction is $60,000 for John (20% x $300,000); however, it is limited to 2.5% of the $1.4 million building and equipment cost, or $35,000. Both the cost of the building and the equipment qualifies, because each asset was owned for the longer of its depreciable life or 10 years as of 2018 – the year John seeks his 20% pass-through deduction.
Originally posted by @Thomas Jones :

The IRS issued more guidance on Wed, Aug 8th on the new Sec. 199A 20% pass-through deduction. But many taxpayers are wondering does this apply to real estate activities as well.

The 20% deduction applies to Qualified Business Income (QBI) from a "trade of business." Capital gains, interest income, and dividends (except from a REIT or PTP) are explicitly not included. The proposed regs are silent as to whether a rental activity is a "trade or business" but instead relies on Sec 162. Sec 163(j)(7)(A) is pretty clear that rental income does not qualify as income from a trade or business, so for purposes of the 20% deduction my guess is it's not likely to qualify either. This also likely includes those who qualify for real estate professional treatment on their taxes (i.e. those with 750+ hours of substantial involvement in real estate).

However, there are a couple areas that may apply to those involved in real estate. The CFR 1.199A mentions:

  • “Both active and passive owners of a trade or business may be entitled to a section 199A deduction”
  • “The proposed regulations extend the definition of trade or business for purposes of section 199A beyond section 162 in one circumstance. Solely for purposes of section 199A, the rental or licensing of tangible or intangible property to a related trade or business is treated as a trade or business if the rental or licensing and the other trade or business are commonly controlled…”

So what likely qualifies?

  1. Management companies – Sometimes taxpayers with lots of rentals consider forming a separate management company. Rentals pay management fees to the management company, which operates as a normal trade or business.
  2. Some operators – Depending on the structure of a real estate syndicate, if the operator receives a management fee or guaranteed payment, then the operator would have Qualified Business Income (QBI) for taking the 20% pass-through deduction. However, profits interest, carry, capital gains, and pass-through rental income do not qualify as QBI. Also, in these instances, if the operator was taxed as a partnership or S-Corp, then there would have to be an allocation to determine the applicable amount of QBI.
  3. Real estate used in a business/self-rentals – Often business owners hold real estate used by a business in a different entity and capitalize that holding entity through a self-rental agreement between the business and holding entity. Self-rentals are subject to unique rules on net rental income and losses, but there are provisions that allow for the activities to be aggregated. So a business owner would include net rental income from the holding entity with the QBI from the business in calculating their 20% deduction under the aggregation rules.
  4. “Box 1” passive investors – Passive investors who receive a K-1 with income in Box 1 “Ordinary business income (loss)” will have QBI.
  5. Realtors and other professionals – Definitely a trade or business. However, these individuals or businesses are considered Specified Service Trade or Businesses (SSTB) and QBI from a SSTB gets phased-out for high income taxpayers.

The rules are complex and there’s a lot not even mention. Taxpayers with foreign assets, multiple businesses, prior year Net Operating Losses, or reasonable officer compensation requirements have even more complex rules involved.

 Thank you for this write-up and information! So to reiterate, as a passive investor in a real estate syndication, would qualify for the 20% pass through deduction? This is great news! I am moving the majority of my real estate equity into privately-funded syndications as a passive investor. The only question I had was, if in the early years the majority of my K1s will show a net loss due to cost segregation analysis, will I benefit even further in this way or will it just be a wash?

@Jack B.  

I'm not going to continue to argue with you. I can't make you understand that you're just incorrect on this unfortunately. 

You're sharing outdated resourced that were published months ago. Regs were posted yesterday. 

MANY tax professionals thought it would apply to rentals early on. That's now proven not likely the case for most situations. 

Again, your theory of just placing something in an entity doens't change it's qualifications in terms of a type of income. 

@Michael Plaks  maybe you have a more clear way to break it down?

Originally posted by @Jack B. :
Originally posted by @Natalie Kolodij:
Originally posted by @Jack B.:
Originally posted by @Natalie Kolodij:

@Michael is spot on. 

A business literally has nothing to do with having an entitiy. 

It's a level of actions and intent defined by IRC section 162. The issue however is they have never made clarity with how it specifically relates to rental income..which typically as it sits...is not trade or business ( that's why you don't pay SE tax on it)

Yes I know, my point was that an LLC is legally a business, so rental properties in an LLC should get the pass through. Try explaining this to the people at Costco when you try to sign up for the Business Executive membership, that not all businesses are an LLC. That's the whole reason I bring this up. I signed up last weekend and they demanded an LLC certificate. I explained as a landlord I pay income taxes on a business, but it's not an LLC. I had to explain not all businesses are an LLC. Hence why I pointed out there are different structures for a business. They themselves don't make it a business. In any case, they wouldn't let me sign up for the business membership because I didn't have an LLC. No matter how much I explained to the "supervisor" that I pay taxes on schedule E for my rentals, and some of them even require a city business rental license, but not an LLC. An LLC is merely ONE option for a business, and technically you should get the pass through if you operate your rentals in an LLC.

Unfortunately that's not how this works. 

They're just calling it a pass through deduction for simplicity. 

It's purpose was to level the playing field when C corps received 1 set, lower tax rate. 

So to take it fair to other pass though entities- they gave them a 20% deduction. 

However there are different TYPES of income generating in any type of entity. If it's not qualify rental income being generated in a LLC/Partnership/ S corp. It still won't qualify

It's the type of income generated in compliance  per Tax code section 162 that matters. Unfortunately you're over simplifying it and you can't just use your interpretation of what makes a pass through override actual IRS  tax code. 

lol, not over simplifying it, read on, this isn't the first tax attorney's blog I've read that states you CAN do this in an LLC or a SP, etc.

http://sctaxlawyers.net/the-new-20-pass-through-de...

https://www.nolo.com/legal-encyclopedia/how-the-re...

For landlords, the most stunningly good provision of the TCJA is a new tax deduction for owners of pass-through businesses. This includes the vast majority of residential landlords who own their rental property as sole proprietors (who individually own their properties), limited liability companies (LLCs), and partnerships. With these entities, any profit earned from the rental activity is “passed through” to the owner or owners’ individual tax returns and they pay tax on it at their individual income tax rates.

  • John owns a 20-unit residential apartment building through an LLC. The apartment building was constructed and furnished in 2012. The original cost of the land was $200,000, the building cost was $1,000,000 to construct, and the fixtures, furnishings and equipment in the building cost another $400,000. The building has a non-accelerated depreciable life of 39 years and the equipment has a useful life of 5 years. In 2018, the LLC has a taxable profit of $300,000. Initially, only the $1.4 million cost of the building and other personal property potentially qualifies; the land does not. The potential 20% pass-through deduction is $60,000 for John (20% x $300,000); however, it is limited to 2.5% of the $1.4 million building and equipment cost, or $35,000. Both the cost of the building and the equipment qualifies, because each asset was owned for the longer of its depreciable life or 10 years as of 2018 – the year John seeks his 20% pass-through deduction.

 Those articles are like...

@Jack B. @Natalie Kolodij

Maybe we can use a different example to further explain the topic...

The Section 199A deduction does not apply to "specified service trades or businesses" (think: accountants, lawyers, doctors, etc.), unless they fall under the income threshold, but that's another story. For purposes of this example, let's assume no specified service trades or businesses qualify.

So, let's assume a lawyer operates under an LLC - the LLC is an entity, formed with the state, but the business activity being conducted within the LLC is a "specified service trade or business" (SSTB). Therefore, the 20% QBI deduction does not apply. It doesn't matter if the law firm is incorporated as a sole proprietorship, LLC, or S Corp; the fact remains that the deduction is not allowed for SSTBs.

The same concept applies to rentals - it doesn't matter whether or not the properties are held in the landlord's name, an LLC, or an S Corp; the activity will still have to be considered a qualified trade or business, which will have to be determined on a case-by-case basis.