The 2017 tax reform introduced a deduction generally equal to 20% of qualified business income (QBI) or the taxpayer’s taxable income, subject to certain limitations. This deduction applies to QBI from a relevant pass-through entity (RPE), such as a sole proprietorship or partnership (including an LLC taxed as either) or an S corporation. Proposed regulations issued on August 16, 2018 clarify the government’s current view of these rules.
Generally, to be QBI, income must be earned by a U.S. trade or business. Whether real estate rental is a trade or business depends on the facts and circumstances. For example, an apartment complex or a commercial building with many tenants, where the landlord provides significant services, generally would be a trade or business. On the other hand, if the landlord leases just one parcel of real estate to only one tenant under a triple net lease where the tenant does all the work and bears all the expenses while the landlord collects a monthly rent check, the rental would probably not constitute a trade or business.
How to qualify for the deduction
The proposed regulations provide a break if the same person or group of persons, directly or indirectly, owns 50% percent or more of the landlord and the tenant, as long as the tenant conducts a trade or business other than a specific service trade or business (SSTB). If the break applies, rental activity that is not a trade or business can qualify as if it were a trade or business, avoiding any concern over whether the rental income is QBI. On the other hand, if rental is tied too closely to an SSTB, the proposed regulations may disqualify part or all of the rental income, even if the rental on its own qualifies as a trade or business. However, the SSTB prohibition applies only if the individual or trust seeking the deduction has taxable income above certain thresholds (for 2018, $315,000 for married filing jointly and $157,500 for other taxpayers).
If rental activity does not qualify for this break, consider the way one’s real estate activity is structured. Each RPE filing its own tax return must separately determine whether its activity rises to the level of a trade or business. Suppose an individual or trust is a landlord holding a portfolio of triple net leases. If each property is held in a separate partnership, each partnership needs to decide whether the triple net lease activity for its own property, viewed in isolation, qualifies as a trade or business. On the other hand, if a partnership is the sole owner of a number of LLCs, each of which is treated as a disregarded entity for income tax purposes, then the partnership can look at all of the activity under its umbrella. Although the proposed regulations allow taxpayers to aggregate their trade or business activity, they can aggregate only what constitutes a trade or business at the RPE level, so the aggregation option does not affect this analysis.
Possible limits to the deduction
If real estate rental constitutes QBI, the deduction of 20% of QBI is limited if the individual or trust’s taxable income exceeds the thresholds described above. In that case, the deduction is limited to the greater of 50% of qualifying wages or the sum of 25% of qualifying wages and 2.5% of the original purchase price (ignoring depreciation or other write-offs) of depreciable property used in the business (the original purchase price is referred to as unadjusted basis immediately after acquisition or “UBIA”). Under the proposed regulations, the ability to use the original UBIA may go away if one places the property in a new business entity (depending on the circumstances). The option to aggregate business activities that are closely tied together allows QBI, qualifying wages, and UBIA to be added together so that a business with more wages and UBIA than it needs can support a QBI deduction for other businesses with insufficient wages or UBIA. The election to aggregate is irrevocable and requires careful analysis.
This article is intended for informational purposes only. It is not intended to provide legal or tax advice to be relied upon without further consultation. If you desire legal or tax advice for your particular circumstances, please consult an attorney or tax professional. Tax professionals are welcome to email me for a free copy of my business structuring materials (and look at part II.E.1.e. Whether Real Estate Qualifies As a Trade or Business) or to attend a free webinar on October 30: Planning Using the Proposed Regulations under IRC §§ 199A and 643(f).
Steve Gorin is a nationally recognized practitioner in the areas of estate planning and the structuring of privately held businesses.