With the passage of the Tax Cuts and Jobs Act (TCJA) of 2017, many real estate investors are wondering whether rental income qualifies for the generous, yet confusing, section 199A deduction against Qualified Business Income (QBI). The answer is it’s not 100 percent clear, but the general consensus among tax practitioners is that income from rental properties will be deemed QBI and qualify for the deduction. Of course, there are always exceptions. The new section 199A deduction is limited to QBI generated from a qualified trade or business within the United States. Real estate ownership and its associated rental income is generally considered to be a passive activity.  Therefore, the question is, if you own rental real estate, are you operating a trade or business to benefit from the deduction or are you just a passive investor?

What is a Trade or Business?

The law is unclear on what constitutes a trade or business. The problem is that “[n]either the statutory text of section 199A nor the legislative history provides a definition of trade or business for purposes of section 199A.” (source: IRS REG 107892-18) The regulation goes on to further state that “section 162(a) provides the most appropriate definition of a trade or business,” but that definition is vague and useless when trying to determine whether owning real estate is considered a trade or business. The general interpretation by most tax practitioners is that owning real estate would be considered a trade or business as long as the owners are involved with the rental real estate with “continuity and regularity.” That means the more actively involved you are in the management of a rental property, the more likely it will be considered a trade or a business. As a result, owners of real property with a triple net lease would not qualify for the deduction. A triple net lease is when the tenant (lessee) is responsible for all the expenses, such as property taxes, insurance, maintenance, etc. In a triple net lease, the owner is not involved with the management of the property and cannot reasonably justify qualifying for the deduction.

W-2 Wages and (UBIA)

Assuming real estate is considered a qualified trade or business, how much a taxpayer can deduct from their rental property is based on their taxable income. For taxpayers with incomes below the taxable income thresholds (see chart below), the deduction is somewhat straightforward. Their deduction is the lesser of: (a) 20 percent of their QBI from their trade or business (rental activity) or (b) 20 percent of taxable income minus net capital gains. Taxpayers with incomes above the taxable income thresholds are limited to the lesser of: (a) their 20 percent of QBI or (b) the greater of 50 percent of W-2 wages from qualified trade or business; or the sum of 25 percent of the W-2 wages from the qualified trade or business, plus 2.5 percent of the Unadjusted Basis Immediately After Acquisition (UBIA).

When calculating UBIA, a property is deemed qualified if it is held by the business during the year and used in the production of QBI, it must also be held by the business at the end of the year. UBIA is just a fancy way of saying the depreciable value of the property when it is initially purchased. Hence, raw land would not qualify because land is not depreciable. A taxpayer must deduct the value of land from purchase price to calculate UBIA. For example, if a taxpayer purchases a real estate property for $1,000,000 and the land is valued at $400,000, the UBIA would be $600,000. In addition, the property must be within its depreciable period when calculating the UBIA (27.5 years for residential property and 39 years for commercial). That means if a property is fully depreciated, it cannot be used to calculate UBIA, unless accelerated depreciation was used and the depreciation period has not ended yet.

Anti-Abuse Provisions

As you can imagine, some taxpayers will attempt to game the system to artificially qualify for the deduction. As a result, the IRS has proposed some anti-abuse provisions to prevent such tactics. For example, to maximize the amount of UBIA, a taxpayer might purchase property at year-end to boost their deduction. IRS Reg 107892-18 states “[p]roperty is not qualified property if the property is acquired within 60 days of the end of the taxable year and disposed of within 120 days without having been used in a trade or business for at least 45 days prior to disposition, unless the taxpayer demonstrates that the principal purpose of the acquisition and disposition was a purpose other than increasing the section 199A deduction."

The 2018 tax-year will cause much confusion among small business owners, including taxpayers who own rental real estate. At face-value, the new 199A deduction on QBI seems simple enough, but its application is actually very complicated as shown above, plus some parts of section 199A have yet to be clarified. For more information on the section 199A deduction against QBI, including how to calculate the deduction using examples, subscribe to our newsletter to receive a copy of our upcoming white paper on the subject.

Ara Oghoorian, CFA, CFP®, CPA is the President & Founder of ACap Asset Management & ACap Accounting Services.

ACap Advisors & Accountant is a “Fee-Only” wealth management and full-service accounting firm headquartered in Los Angeles, CA specializing in helping doctors and healthcare professionals make sound financial decisions.

Contact ACap at info@acapam.com or 818-272-8511.