Under the 2017 Tax Cuts and Jobs Act, owners of pass-through businesses such as partnerships, S corporations, and sole proprietorships might qualify for the qualified business income (QBI) deduction on their tax returns for years 2018 through 2025. There are certain thresholds and other requirements that must be met to qualify for the deduction. If met, this 20% deduction on qualified business income can provide a decent tax break for businesses that do not operate as C Corporations.
HOW TO QUALIFY
To qualify for the deduction, an individual taxpayer’s trade or business income must be derived from:
Partnerships (not including publicly traded partnerships — see the following discussion);
LLCs taxed as partnerships or S corporations;
Schedule C businesses;
Schedule F farming activities; and
Self-employment income reported as other income.
The deductible amount for each qualified trade or business is the lesser of:
a) 20% of its QBI, or
b) the greater of either 50% of its wages, or
c) 25% of its wages plus 2.5% of its unadjusted basis immediately after the acquisition of all qualified property
For taxpayers that own a real estate business or SSTB, the deduction begins to phaseout for earnings over $315,000 for married filing jointly, and $157,500 for single filers. For these filers, the 2018 deduction is limited to a percentage of wages paid with respect to the trade or business, or the combination of a percentage of wages paid, plus a percentage of the unadjusted basis of the property.
SERVICE TRADES OR BUSINESSES (SSTBs)
Certain service trades or businesses are not eligible for the deduction. The IRS defines an SSTB as:
A trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners. The principal asset of a trade or business is the reputation or skill of its employees or owners if the trade or business consists of the receipt of income from endorsing products or services, the use of an individual’s image, likeness, voice, or other symbols associated with the individual’s identity, or appearances at events or on radio, television, or other media formats. The SSTB exception does not apply for taxpayers with taxable income below the threshold amount and is phased in for taxpayers with taxable income above the threshold amount.
The IRS recently issued Notice 2019-07 to provide a safe harbor for rental real estate owners to qualify for the 20% deduction on the rental income. The purpose of this safe harbor is to provide guidance that will allow taxpayers to demonstrate they are operating a real estate business as opposed to holding real estate solely for investment.
In order to qualify for the 20% deduction, the rental properties must be treated as a rental real estate “enterprise” and qualify as a trade of business for purposes of Section 199A. A rental real estate enterprise is defined as an interest in real property held for the production of rents. It may consist of multiple properties, but if taxpayers combine multiple properties for purposes of determining whether they are engaged in a rental real estate enterprise, they must continue this treatment from year-to-year unless there has been a significant change in facts and circumstances. Commercial and residential property may not be part of the same enterprise. Therefore, for purposes of the safe harbor, a taxpayer with both residential and commercial properties must meet the requirements separately with respect to each.
There are three requirements to meet in order to be qualified for the safe harbor:
Separate books and records must be maintained to reflect income and expenses for each rental real estate enterprise.
At least 250 or more hours of rental services must be performed per year with respect to the rental enterprise. For tax years beginning after December 31, 2022, this test can be satisfied in any three of the five consecutive tax years that end with the tax year.
The taxpayer must maintain contemporaneous records of relevant items, including time reports, logs, or similar documents. (This requirement does not apply to tax years beginning in 2018.) Relevant items include hours of all services performed, description of all services performed, dates on which such services were performed, and who performed the services.
The rental services for the 250-hour requirement do not include financial or investment activities, such as:
studying reports on operations;
planning, managing, or construction of long-term capital improvements; or
hours spent traveling to and from the real estate.
To take advantage of the safe harbor, the taxpayer must attach a signed statement, under penalties of perjury, that the requirements of the safe harbor have been met.
This deduction will sunset in 2025.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisers before engaging in any transaction.