In addition to having unique income-plus-appreciation-potential investment characteristics as an asset class unto itself, one of the primary benefits of directly investing in real estate is its favorable tax treatment, where capital gains are deferred until sold (and potentially further deferred with a 1031 exchange), and ongoing rental income can be at least partially offset by depreciation deductions.
In December of 2017, the Tax Cuts and Jobs Act further extended the benefits of investing in real estate by introducing a new “qualified business income” (QBI) deduction under IRC Section 199A that further reduces net rental real estate income by up to 20%.
The caveat, however, is that recent Treasury Regulations have clarified that not all direct real estate investing will actually qualify for the Section 199A deduction. Instead, investors must be able to demonstrate that they are operating a real estate “business” in order to qualify and show that either they personally, or other employees of the business, are spending a substantial amount of time actually engaged with the real estate (to differentiate a business from a mere real estate “investment” instead).
Furthermore, the QBI deduction for real estate investors may be further limited by the so-called “wage-and-depreciable property” test, which for high-income taxpayers (married couples filing joint returns with taxable income above $315,000, and taxable income above $157,500 for all other filers) typically partially or fully caps the maximum deduction at 2.5% of the original (i.e., “unadjusted”) basis of the property, plus 25% of the wages paid to employees in the business.
Nonetheless, the opportunity to deduct 20% of a real estate business’s net income provides substantial potential tax savings, making direct real estate investing even more appealing. Especially since, for those truly engaged in a real estate business with multiple properties, aggregation rules make it possible to group real estate investments together in a manner that at least eases the challenges of navigating the wage-and-depreciable-property test in the first place!
(Michael’s Note: This post was written by Jeffrey Levine, CPA/PFS, CFP®, CWS®, MSA. Jeff is the Director of Advisor Education for Kitces.com, CEO and Director of Financial Planning for BluePrint Wealth Alliance (where he drives the firm’s vision of delivering a unique, modern approach to the financial, tax, and estate planning), and is the Lead Creator and Content Expert for Savvy IRA Planning®, offered through Horsesmouth. Jeff is a recipient of the Standing Ovation award, presented by the AICPA Financial Planning Division, and was named to the 2017 class of 40 Under 40 by InvestmentNews. Previously, Jeffrey served as Ed Slott and Company’s Chief Retirement Strategist, where his ability to simplify the complex laws that govern individual retirement accounts, combined with his unique blend of humor and tax planning, was first recognized. Jeffrey continues to be an active speaker, traveling the country each year to educate thousands of Financial Advisors, CPAs, Attorneys and consumers on retirement, tax, and estate planning strategies. You can follow Jeff on Twitter @CPAPlanner and via his personal website Fully Vested Advice.)
Calculating the QBI Deduction For (Direct) Real Estate Investors
There are many benefits – both tax and otherwise – to directly owning real estate; from the investment potential for stable income plus the rising value of a capital asset, to the depreciation deductions that help to shelter the taxation of real estate income.
The significance of the Tax Cuts and Jobs Act of 2017, though, was the introduction of a prospective new tax benefit for real estate investing – the opportunity to claim the new 20%-of-income Section 199A “pass-through” deduction, which applies not only to “traditional” pass-through businesses, but also real estate businesses, whether that rental real estate is owned personally or in a disregarded entity (i.e., a Single Member LLC) (with income and/or losses attributable to those properties reported via IRS Form Schedule E), or with other investors via partnerships or S corporations (where the investors receive Schedule K-1s annually).
Only “Qualified” Real Estate Businesses Generate QBI Deductions
While the new IRC Section 199A rules clearly intended for at least some real estate income to qualify for the QBI deduction – because, as discussed later, there are specific limitations on how the deduction applies to real estate businesses – one of the biggest limitations of the deduction is simply that it only applies to a “qualified trade or business” in the first place. As IRC Section 199A(C)(1) states:
“The term ‘qualified business income 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.” (emphasis added).
The significance of this provision is that it raised questions as to when/whether an investment in real estate constitutes a real estate business eligible for the QBI deduction, versus “just” being an investment. And initially, there was widespread disagreement amongst practitioners as to how the IRS would define a “qualified trade or business”… which was complicated by the fact that there are several different definitions of trade or business that can be found throughout the tax code already.
Some experts believed that the IRS would take a fairly liberal view of what constitutes a trade or business for purposes of the 199A deduction, and pretty much qualify all income generated from real estate activities as QBI. Others believed the IRS would define “qualified trade or business” more narrowly, and thus, potentially limit the availability of the deduction for some real estate investors.
Ultimately, proposed regulation 1.99A-1(b)(13) provided this answer:
“Trade or business means a section 162 trade or business other than the trade or business of performing services as an employee.
In addition, rental or licensing of tangible or intangible property (rental activity) that does not rise to the level of a section 162 trade or business is nevertheless treated as a trade or business for purposes of section 199A, if the property is rented or licensed to a trade or business which is commonly controlled under §1.199A-4(b)(1)(i) (regardless of whether the rental activity and the trade or business are otherwise eligible to be aggregated under §1.199A-4(b)(1)).” (emphasis added)
The good news is that, in no uncertain terms, the proposed regulations tell us that for purposes of the 199A deduction, the IRS is defining “trade or business” in the same manner as it does for IRC Section 162. The bad news is that this definition of “trade or business” is itself ill-defined, and raises particular concerns for some real estate investors.
Over the years, what rises to the level of a Section 162 business has been largely borne out by the courts, which have generally stipulated that in order to qualify as a business, “the taxpayer must be involved in the activity with continuity and regularity.” But what exactly qualifies as “with continuity and regularity?” That’s the rub… it’s a largely subjective matter and must be determined on a case by case basis, taking into account things like hours spent in the business, and in the case of real estate businesses, the number and type(s) of properties rented and the nature of the lease agreements.
Types Of Real Estate “Businesses” That Qualify For The QBI Deduction (Or Not)
Since the proposed regulations were released, experts have continued to speculate as to which types of rental activities or real estate investments will qualify as a trade or business for IRC Section 199A purposes. Although there continues to be a fairly wide disparity between opinions, some things appear clear, including:
- Triple-net leases increase the chances of a rental property not rising to the level of a trade or business. In a triple-net lease, a tenant is responsible for the payment of the lease, the taxes on the property being leases, as well as repairs and maintenance on the property. So if all that’s being handled by the tenant, what’s the landlord doing? Pretty much, just collecting a check… and that’s a potential problem. As such, real estate investors looking for the best opportunity to claim the Section 199A deduction may wish to avoid using triple-net leases (unless they’re held in/via a REIT).
- Investors should keep track of their time (and the time others spend) working for the real estate business. Time spent in the business for rental properties can include regular visits to inspect the property, paying bills, searching for tenants, and researching, hiring, and coordinating vendors to maintain or improve the property.
- The greater the number of unit of real estate rented, the greater the chance that the IRS (and, if necessary, the courts) will deem the activity rises to a “trade or business.”
- Clients with minimal involvement in rental activities should be prepared for the possibility that any QBI deduction claimed to be challenged upon audit.
In other words, the new Section 199A regs make it clear that merely owning rental real estate that generates rental income is not a trade or business of being a real estate investor, and as such, wouldn’t qualify for the QBI deduction. The investor must truly operate the real estate investments as a business of real estate investing to actually qualify for the QBI deduction on that rental income.
Income Limitations On QBI Deductions For Direct Real Estate Investors
Once a real estate investor’s activity is deemed a qualified trade or business, any net income from the business will be QBI and eligible for a potential 199A deduction.
For investors with taxable income below their applicable threshold ($315,000 for married couples filing joint returns, and $157,500 for all other filers), the calculation of the QBI deduction is fairly straightforward.
For real estate investors with high income, though, there is both good news and bad news. The good news is that rental real estate is not a “specified service trade or business,” and thus a real estate investor’s QBI deduction is not necessarily phased out automatically just because their income exceeds the applicable thresholds. The bad news, though, is that once a real estate investor’s taxable income exceeds their applicable threshold, the calculation of the QBI deduction becomes much more complicated and may still be reduced or eliminated entirely.
Specifically, a high-income real estate investor’s QBI deduction is limited to the lesser of their QBI, or the greater of 50% of their W-2 wages paid, or 25% of W-2 wages paid plus 2.5% of the unadjusted basis of its depreciable property immediately after acquisition.
Determining the amount of W-2 wages paid by the business is generally simple enough. It’s likely readily available by examining the business’s books, but if not, it can be found on the year-end Form W-3 that is required to be filed with the IRS.
Determining the “unadjusted basis of depreciable property immediately after acquisition” on the other hand? Not so much.
Calculating “Unadjusted Basis Of Depreciation Property Immediately After Acquisition” For Real Estate QBI Deductions
When calculating the unadjusted basis of depreciable property immediately after acquisition, the basic principle is straightforward – literally, it’s based on the unadjusted basis of the property immediately after it was acquired. Thus, if a real estate investor bought a building for $1 million, and it’s now been depreciated to only $400,000 of remaining basis, the “basis” limitation for the QBI deduction is calculated with the original $1M basis, and not just the $400,000 remaining.
However, in practice, the determination of “unadjusted basis of depreciable property immediately after acquisition” is more complicated, for several reasons, including:
- Only tangible, depreciable property is counted. Thus, if a real estate investor buys a building for $1 million, and $100,000 of the purchase price is allocated to the land the building sits on, “only” $900,000 – the portion of the purchase payment allocated to the building and eligible for depreciation – can be counted towards the unadjusted basis of depreciable property immediately after acquisition.
- The property must (still) be owned at the end of the year. The 199A proposed regulations make clear that in order to be counted towards the unadjusted basis of depreciable property immediately after acquisition, the property must be owned as of the end of the tax year. As such, real estate investors looking to sell property late in their tax year may benefit from delaying the sale of that property until the start of their new tax year. On the other hand, buyers may wish to purchase real estate prior to the end of their tax year in order to use the unadjusted basis to reduce the impact of the wage-and-depreciable-property limitations on other QBI generated within the same real estate business (or within an aggregated group of businesses, as discussed further below).
Note: The proposed regulations do include an anti-abuse rule that prevents real estate investors from temporarily buying up property at the end of the year just to artificially boost the basis calculation for their QBI deduction. Specifically, if a property is acquired within 60 days of the end of the tax year, then its basis only counts towards the “unadjusted basis of depreciable property immediately after acquisition” if it is held for at least 120 days, or unless the property was used at least 45 days for business prior to its subsequent disposition.
- Only property that is still within its “depreciable period” is counted. In general, residential real estate is depreciated over a 27.5 year period, while commercial real estate is depreciated over a 39 year period. Thus, once these periods have elapsed and a property has been fully depreciated to a cost basis of $0, it can no longer be counted as part of the unadjusted basis of depreciable property immediately after acquisition.
- Additional first-year depreciation does not reduce the “depreciable period.” Notwithstanding the prior constraint, any additional first-year depreciation under IRC Section 168 (that could depreciate the building to a basis of $0 even faster) does not affect the depreciable period. Therefore, if a residential building purchased 25 years ago is already fully-depreciated to $0 basis because of additional first-year depreciation claimed under IRC Section 168, the property is still eligible to be included in the “unadjusted basis of depreciable property immediately after acquisition” calculation for another 2 ½ years (until the 27.5 year standard depreciation period has run its course).
Understanding these “basic” rules surrounding the unadjusted basis of depreciable property immediately after acquisition will allow you to determine the QBI deduction of a real estate investor who is above their applicable threshold.
Example #8: Phil and Rose are married and file a joint return. In 2018, they have $600,000 of taxable income, putting them well above the upper-end of the $315,000 – $415,000 phaseout range for married couples.
$400,000 of the couple’s income is attributable to rental income, which is reported on Schedule E of their tax return. As such, they would generally be entitled to an 80,000 ($400,000 x 20% = $80,000) QBI deduction. However, since their income is above their applicable threshold, the wages and wage-and-property tests must be applied to see if the QBI deduction must be reduced.
During 2018, Phil and Rose’s real estate business paid $50,000 of wages to a property manager. Furthermore, the original depreciable basis of their real estate properties was $2 million.
Using the 50%-of-wages test, Phil and Rose’s QBI deduction would be dramatically decreased from $80,000 to $25,000 ($50,000 x 50% = $25,000).
Using the 25%-of-W2-wages-plus-2.5%-of-the-unadjusted-basis-of-depreciable-property test, however, produces a more favorable result. 25% of the wages paid equals $12,500. Furthermore, 2.5% of the $2 million of the unadjusted basis of the real estate is $50,000. Combined, these amounts would limit Phil and Rose’s QBI deduction to $62,500. That’s substantially more than the $25,000 calculated using the first test, though still materially less than the $80,000 QBI deduction Phil and Rose would otherwise been eligible to claim.
Impact Of Wage-And-Property QBI Tests On Rising Real Estate Prices And Cap Rates
In reality, the wage-and-property test limitation is most likely to impact those individuals operating rental businesses in which the rental property was purchased many years ago. In contrast, those purchasing real estate today are likely to see substantially all of their rental profits eligible for the QBI deduction.
Consider, for instance, that a 10% “cap rate” (net operating income divided by current market value) would generally be considered a fantastic cap rate most real estate markets today. If a real estate investor purchased a $1 million property with a 10% cap rate, the property would generate $100,000 of income before any deductions for depreciation. Still, even if the depreciation deduction is ignored, the $100,000 of QBI rental income would potentially be eligible for a $20,000 QBI deduction. At the same time, 2.5% of the newly purchases property is $25,000. That more than covers the potential $20,000 QBI deduction, without even considering any W-2 wages paid! And of course, at lower cap rates, it would just be even easier for the income to qualify.
On the other hand, if the property was purchased many years ago for “just” $500,000 (such that the property and its income have since doubled), the QBI deduction would be capped at just $12,500 (plus 25% of wages)… a substantial limitation to the $20,000 of current income that was tied to the cap rate on current market values.
Notably, this “gift” to real estate investors – lifting the QBI limitation to be constrained not just by the wage test, but also a wage-and-property test that considers the property’s (original) basis – was thrown in at the final moments before the Tax Cuts and Jobs Act was passed, which originally did not include the 2.5%-of-depreciable-property limitation, and thus would have constrained real estate QBI deductions to just the likely-even-harsher 50%-of-wages test. As a result, it became a politically sensitive focal point of Democrats, who ultimately coined the provision the “Corker Kickback” after Republican Senator Bob Corker, who is known to hold substantial real estate and will likely personally benefit rather substantially from the provision’s inclusion.
Leveraging The Aggregation Rules (Grouping) To Maximize The QBI Deduction On Real Estate
Relative to many other businesses that also have few employees (and thus pay little in wages and would be very constrained by the 50%-of-wages test), real estate investors sit in pretty good position when it comes to receiving a QBI deduction, thanks in large part to the substantial depreciable assets that are naturally associated with the business.
Nevertheless, there are a number of strategies that may be able to help such real estate investors further maximize their potential QBI deduction and navigate the wage-and-property-test constraints.
When IRC Section 199A was first created as part of the Tax Cuts and Jobs Act, one of the biggest questions on practitioners’ minds was whether the IRS would allow “grouping elections,” similar to elections currently available for passive activity losses and net investment income tax purposes. Grouping elections are often helpful for tax rules that have caps or limits, as by aggregating multiple investments together, they often can better navigate limits together than may apply if each was calculated individually.
Not surprisingly, the newly proposed Section 199A regulations do include such an option, referred to as “aggregation”… but only in limited circumstances.
In general, the proposed regulations require that “each trade or business is a separate trade or business for purposes of applying the limitations described in §1.199A-1(d)(2)(iv),” which outline the wage/wage and depreciable property tests. However, under the proposed aggregation rules, multiple trades or businesses may be combined for testing purposes as long as:
- The same person or group of persons, directly or indirectly, owns 50% or more of each trade or business for a majority of the tax year. (Family attribution rules apply as well to determine “same person or group of persons.”)
- All of the items attributable to each trade or business to be aggregated are reported on returns with the same taxable year (other than in the case of a short year).
- None of the businesses are a specified service trade or business (SSTB).
- At least two of the following apply:
- The businesses provide products and services that are customarily offered together.
- The businesses share facilities or significant centralized business elements.
- The businesses are operated in coordination with, or reliance upon, one or more of the businesses in the aggregated group.
In other words, the aggregation rules limit real estate investors from just arbitrarily investing into more (otherwise unrelated) businesses and grouping them together to navigate around the wage or wage-and-property QBI limitations. While also requiring that certain commonly-owned common-purpose businesses be aggregated together to prevent their owners from separating out the businesses where it would be inappropriate to do so (e.g., when an individual’s business A leases property from related real estate investment B).
Nonetheless, these aggregation rules may provide significant benefit to real estate investors in a number of circumstances.
One likely scenario, for instance, is the ability for high-income real estate investors to use recently-purchased, high-basis property to help shield QBI from older, fully-depreciated property, from being phased out.
Example #10: Rachel is a high-income retiree. Roughly 30 years ago, Rachel purchased a small apartment building in a Single Member LLC for $250,000. The property has since been fully depreciated, and is currently valued at $6 million. Rachel’s annual profit from the building for 2018 is projected to be $350,000.
Rachel does not pay a property manager, and since the apartment building is outside of the “depreciable period,” she is not able to use even its $250,000 initial purchase price for QBI-deduction testing purposes. Thus, Rachel’s potential QBI deduction of $70,000 ($350,000 x 20% = $70,000) will be reduced to $0 (the “greater” of her $0 wages and $0 of wage-and-depreciable-property tests).
Suppose, however, that at the same time Rachel bought her apartment building, her brother, Raphael, bought the exact same building next door in his own Single Member LLC, and is generating the same $350,000 of annual profit. Unfortunately though, Raphael dies, leaving the LLC and building to Rachel.
In general, Rachel would have to treat these activities as separate businesses. However, under the aggregation rules outlined in the proposed regulations, Rachel could make an election to aggregate the two real estate businesses together for testing purposes.
If such an election were made, the combined entity would have $700,000 of profit, $0 of W-2 wages paid, but thanks a step-up in basis on Raphael’s apartment building, a $6 million amount of unadjusted basis of depreciable property immediately following acquisition. Thus the calculation of Rachel’s QBI deduction would be as follows:
- $140,000 ($700,000 x 20% = $700,000) potential QBI deduction
- $150,000 ($6,000,000 x 2.5% = $150,000) deduction “limit” using the 25%-of-W2-wages-plus-2.5%-of-the-unadjusted-basis-of-depreciable-property test
Since Rachel’s QBI deduction “limit” would be higher than her QBI deduction calculated without regard to any phaseout, she would be able to claim a “full” QBI deduction. Thus, by making the grouping election between the property she purchased 30 years ago and her second inherited piece of real estate with high basis, Rachel not only received a QBI deduction for the profits attributable to her new “business,” but she was able to shield the existing profits for which she was otherwise unable to receive any QBI deduction as well!
While the election to aggregate multiple businesses may seem like a home run in certain circumstances, careful considerations should be given not only to the election’s current impact, but its impact on future taxes as well. Because the proposed regulations do stipulate that although new businesses may be added to an existing aggregation group at the time of acquisition, once a group of businesses has been aggregated, they must generally remain aggregated unless there is a change in facts or circumstances such that they no longer qualify for such aggregation.
The Section 199A QBI deduction is one of the most significant tax benefits to be added to the Internal Revenue Code in decades. And while all sorts of business owners stand to benefit from its power, the fact that at least some direct-owned real estate investors qualify as well means the 199A deduction is about more than “just” traditional operating businesses. As such, real estate investors and potential real estate investors should take the time to carefully analyze how the QBI deduction will impact them, what strategies they can use to maximize the deduction, and whether any changes in how or where their real estate is owned is appropriate.