What is Section 199 A?
In the year 2017, American President Donald Trump signed the 2017 Tax Cuts and Jobs Act, it includes the enactment of Section 199A of the Internal Revenue Code or the Qualified Business Income Deduction (QBID). It provides for the new 20% deduction for qualified trade or business operated directly or through a pass-through business. Individuals, trusts and estates with qualified business income, qualified REIT dividends or qualified PTP income may qualify for the deduction. Qualified Business Income is the net amount of qualified items of income, gain, deduction and loss from any qualified trade or business. Only items included in taxable income are counted. The qualified items must be connected with a U.S. trade or business and it excludes capital gains and losses, certain dividends and interest income.
The qualified business or trades are domestic businesses operated as a sole proprietorship or through a partnership, S corporation, trust or estate shall deduct of not more than 20% of the earned income. This new deduction allows business owners to keep pace with the significant corporate tax cut also provided by the Act. Taxpayers may also be entitled to a deduction of up to 20% of they are combined qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income.
The significance of Section 199 A
Under this new rule, the real estate industry is given a favor of not more than 20% allowable deductions for a certain type of income. The active rental of real estate, being a dealer or developer in real estate, and other associated activities and vocations can qualify, but several special rules apply. Generally, for single filing individuals, trusts and estates with taxable income of below $157,500, and married couples filing jointly with taxable income under $315,000 will qualify for the deduction regardless of whether or not the applicable activity or entity satisfies certain wage and qualified property hurdles. This new IRC regulation does not qualify as a trade or business of the real estate when it is merely owning rental real estate that generates rental income, and would not 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.
For the income earners, married couples filing joint returns with taxable income above $315,000, and taxable income above $157,500 for all other filers, the QBI deduction for real estate investors is conditioned by the so-called wage-and-depreciable property test. The high-income earner’s deduction is partially or fully caps the maximum deduction at 2.5% of the original basis of the property, plus 25% of the wages paid to employees in the business. As a sample scenario: James has seven rental properties which are triple-net leased and, as a landlord, James does not engage in an active managerial or any business activity associated therewith, such as actively buying and selling rental properties, the 20% deduction will not be available. For instance, James is a high-income earner or above the threshold, he cannot take any deduction under Section 199A, unless the wages or qualified property test is satisfied. This test that applies to high earners limits the Section 199A deduction to the greater of 50% of the taxpayer's share wages paid by the Section 199A businesses or the sum of (a) 25% of wages and (b) 2.5% of the taxpayer's share of the unadjusted basis of qualified property.
If James’ personal taxable income is between the base of $157,500 and $207,500 if single, or between $315,000 and $415,000, if married filing jointly, and if the wage or qualified property test is not satisfied, a “phase out” occurs that is in proportion to where the income lays threshold brackets of the two amounts, regardless of whether the wage or qualified test applies. It will be more complicated if the test is only partially satisfied.
The IRC Section 199A QBI deduction is one of the most significant tax benefits. The business owners will benefit from it and some direct-owned real estate investors qualify to the 199A deduction which is more than the traditional operating businesses. It will take time to fully understand and analyze how the QBI deduction will impact the real estate investors and potential real estate investors on what strategies they can use to maximize the deduction.