Section 199A: Legally Avoid Taxes on the Last 20% of Income???

Question

My friend, The Mad Fientist (guest on  BiggerPockets Money Episode 18) is a huge fan of legal tax avoidance.

His accountant asked for a tshirt from him, and in exchange, he got an article about "the most exciting new tax break to be released in decades." (Read here: https://www.madfientist.com/section-199a/)

AND it includes real estate investments.

Any of my RE tax peeps want to chime in with tips for using this properly?

Michael Plaks · Answer

@Mindy Jensen

Yeah, we seemingly massaged this topic to death over the past few months.

But behind all the details explained by @Nicholas Aiola, let's keep the big picture in perspective. This is NOT a "20% of income" deduction, as it is most often described. It is 20% of whatever is left after all deductions. For landlords, it means after depreciation, as well.

For the majority of landlords, it will change absolutely nothing, as they show losses after depreciation.

For a wholesaler, here is an example.

• All assignment fees for the year are $100k. 
• Marketing is $20k. 
• Driving is $15k. 
• Supplies, cell phone etc  $3k
• Home office $2k.
• His 20% deduction is $12k (20% of what is left), not $20k (20% of $100k)!
• His actual tax savings are maybe $4k.

Yes, certainly a welcome break, but not as much as many people expect.

Nicholas Aiola · Answer

@Mindy Jensen Great article!

The Section 199A 20% QBI deduction is certainly a blessing... For those who can actually take it.

First, the business itself needs to be a "qualified trade or business". Second, the individual has to qualify separately for the ability to take the deduction (based on  limitations such as income and possibly wages paid by or real property held by the business). The calculations and limitations can get a bit complex.

There are a host of businesses--called specified service trades or businesses (think: lawyers, accountants, doctors, etc.)--who cannot take the deduction unless the owners fall under predetermined income limits based on their filing status.

Landlords, however, are not explicitly listed as allowed or disallowed businesses with respect to Section 199A; it will, theoretically, be a case by base basis.

That said, prior case law suggests that rental income will qualify for the 20% deduction as long as the landlord is active in the "business". For example, managing the property, making decisions, being involved in the purchase process, financial decisions, bookkeeping, etc. A non-active investment (like a NNN lease) would be hard to justify.

There is no specific amount of properties or portfolio size needed to qualify as a "trade or business"; there are cases that ruled a landlord with one rental property as operating a "trade or business". There is even case law supporting a rental with a paid property manager as a trade or business.

There are other factors to consider, for sure, but it seems to me (and I believe most other tax pros on BP) on a very general level that the ordinary rental property will qualify for the 20% deduction.

I'm certain we will get further guidance on how this applies to landlords specifically in the (hopefully near) future.

As @Kyle J. mentioned, those threads include some great discussion and further details.

Christopher Smith · Answer

For those of us that do currently generate substantial taxable income from our rental properties (with or without a manager), something I found just kicking this topic around on line below:

"Rental Property as Business

Owning rental property qualifies as a business if you do it to earn a profit and work at it regularly, systematically, and continuously. (Alvary v. United States, 302 F.2d 790 (2d Cir. 1962).)

Example: Edwin Curphey, a dermatologist, owned six rental properties in Hawaii. He converted a bedroom in his home into an office for his real estate activities. Curphey personally managed his rentals, which included seeking new tenants, supplying furnishings, and cleaning and otherwise preparing the units for new tenants. The court held that these activities were sufficiently systematic and continuous to place him in the business of real estate rental. (Curphey v. Comm’r., 73 T.C. 766 (1980).)

However, you don’t have to do all the work yourself: You can hire a manager to help you and still qualify as a business.

Example: Gilford, her two sisters, and other relatives jointly owned eight apartment buildings in Manhattan. They hired a real estate agent to manage the properties and pay each family member their share of the net income. Gilford was found to be in business even though she spent little or no time managing the buildings. The court reasoned that the ownership and management of the buildings was a business because it required considerable time and effort by the real estate agent over several years. Because the agent acted for Gilford and was ultimately under her control, Gilford was in business through her agent. (Gilford v. Comm’r., 201 F.2d 735 (2d Cir. 1953).)

There is no specific number of rental properties or rental units you must own for your rental activity to qualify as a business. In one case, a married couple was found to be engaged in business even though all they owned was a 25% time-share interest in two condominium units. And, the actual work of renting out the units and keeping them in repair was performed by a management company that acted as their agent. (Murtaugh v. Comm’r., T.C. Memo 1997-319.) Indeed, several courts have stated that a landlord who owns a single rental property can be engaged in business. (Balsamo v. Comm’r., T.C. Memo 1987-477.)"

Seems to offer some support for taking a credible position that 199A is available if you have the right facts.

Michael Plaks · Answer

@Dmitriy Fomichenko

I mostly agree with @Nicholas Aiola, minus the private lender part. It better be a business-like operation similar to HM. Multiple loans, processes, in-house valuations, inspections etc.  Most casual PLs do nothing besides drinking cocktails at REI socials twice a month and signing papers twice a year.

Caveat: it will also expose the (formerly) interest income to the self-employment tax. So you're saving 20% but adding 15%.

And of course, the risk of the IRS reclassifying it.

The real reason to move a PL operation under the "trade or business" umbrella would not be to qualify for the 20% deduction but to obtain a clear path to deducting all business overhead - which is no longer possible via the old Schedule A route.

Mark Sewell · Answer

Thank you @Michael Plaks for providing a simple and straightforward case study.

Clearly these are the kinds of problems we are all striving for.

Nicholas Aiola · Answer

@Dmitriy Fomichenko

I agree with @Michael Plaks - the deduction will be calculated at the entity level and reported on your K-1.

Whether you can take all or some of the deduction depends on your individual (join) taxable income.

Michael Plaks · Answer

I believe the deduction will be taken at the partnership level and built into your K1.

Nicholas Aiola · Answer

@Dmitriy Fomichenko Note investing is passive and would not qualify, whether the investments were held in an entity or individually.

Interest income would be considered QBI if you were in the business of lending money. For example, a private or hard money lender. In cases like that, interest is no longer considered portfolio income; it's ordinary business income.

The proposed Section 199A regs clarify that lending is not considered a specified service trade or business, so interest income earned by an individual or pass-through entity that's in the business of lending would qualify for the 20% deduction (subject to the limitations, thresholds, and phaseouts).

Dmitriy Fomichenko · Answer

@Nicholas Aiola and @Michael Plaks,

I understand that interest income would not qualify for this deduction. Is there any way to make that "qualified trade or business"? Holding note portfolio in an entity instead of personally? Any strategies on how to apply this deduction to interest income?

Kyle J. · Answer

Hey Mindy, there were actually a couple interesting discussions on the topic recently that are worth a read:

https://www.biggerpockets.com/forums/51/topics/602045-pass-thru-deduction-landlords-new-regs

https://www.biggerpockets.com/forums/51/topics/601141-the-new-20-pass-through-deduction-and-you

Section 199A: Legally Avoid Taxes on the Last 20% of Income???

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