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Most residential and commercial investors own their rental property as sole proprietors, single member LLC's (SMLLCs), LLCs, S Corporations or partnerships. If the rental activity qualifies as a trade or business for tax purposes, the client may be eligible to deduct an amount equal to 20% of the net rental income in addition to the rental-related deductions you are accustomed to. Rental real estate subject to a triple net lease would not qualify as a trade or business, but rental real estate will normally qualify as a trade or business under the Tax Cuts and Jobs Act. (Sec. 199A)
All taxpayers, except C corporations, with Qualified Business Income from a qualified trade or business may take the Sec. 199A deduction. This deduction is applied at the partner (or shareholder) level for owners of pass-through businesses. The deduction also applies to income from a qualified real estate investment trust (REIT) and qualified publicly traded partnership (PTP) income.
Calculation of the Sec. 199A Deduction for Rental Real Estate
- Determine the net income from the rental real estate as you normally calculate net income. Calculate 20% of the net income. The amount calculated may be limited by three factors. The following limiting factors do not apply if taxable income is below $315,000 for married filing jointly or $157,500 for all other taxpayers.
- Calculate 50% of the wages deducted in arriving at net income from the rental activity. The Sec. 199A deduction cannot exceed the larger of this wage calculation or the calculation that follows.
- Calculate the total of 25% of wages deducted in arriving at net income from the rental activity plus 2.5% of the original purchase price of certain property used in the rental business. Property that qualifies for the 2.5% calculation is generally property subject to depreciation or property acquired in the last ten years, excluding intangible assets and land. An example of an intangible asset would be loan costs that are amortized over the life of the loan.
- The third Sec. 199A limiting factor is a limitation based on 20% of taxable income less capital gains.
Many rental activities do not require employees to operate the business. Tasks that involve services are often paid to contractors, such as landscape work, repair services, or property management. Some rental activities do involve employees due to the scope of the rental business.
Mr. and Mrs. Brown own two commercial buildings which are rented to tenants through a property management company. The net income from their rentals is $60,000. They have no employees. The original cost of depreciable assets eligible for the Sec. 199A depreciation calculation is $1,600,000. 20% of the $60,000 of net income equals $12,000. 2.5% of the eligible depreciable assets equals $40,000. The allowable Sec. 199A deduction is $12,000 in this example if the taxable income net of capital gains exceeds $60,000.
If the Browns have additional income from REIT dividends or qualified publicly traded partnership income, they would qualify for an additional Sec. 199A deduction.
If the net income to the Browns from their rentals was $250,000 and their taxable income net of capital gains was over $415,000, the initial Sec. 199A calculation of $50,000 would be limited to $40,000 based on the depreciation limitation. When taxable income net of capital gains is under $315,000 for a married couple, the wage and depreciation limitations do not apply. As taxable income increases beyond $315,000 the Sec. 199A deduction is subject to wage and depreciation limitations.
Mr. and Mrs. Smith own several residential properties in a single member LLC. They have a bookkeeper, full-time property manager, and a full-time maintenance person employed to run their portfolio of properties. Many of the properties were purchased more than 30 years ago and are fully depreciated. The cost of qualifying depreciable assets is $600,000. The wages paid in the past year total $250,000 and the net income from the SMLLC for the year equals $300,000. Their taxable income is $420,000. What is their Sec. 199A deduction? 20% of $300,000 net income equals $60,000. 50% of $250,000 of wages paid is $125,000. 25% of wages paid equals $62,500. 2.5% of $600,000 of qualified depreciable assets equals $15,000. The combination of 25% of wages, $62,500, and depreciation, $15,000, equals $77,500. The Sec. 199A deduction is $60,000. Both measurements that would potentially limit the Sec. 199A deduction are larger than the 20% deduction. The taxable income limitation is $84,000 in this example.
Are There other Limitations to Qualify for the Sec. 199A Deduction?
The Sec. 199A deduction does have limitations related to certain specified service, trade or business. These limitations are directed at "service" businesses where personal services are a key element. Real estate is not a specified service, trade or business, so it is not subject to the limitations that follow.
Taxable Income Below $315,000 for Married Filing Joint (MFJ) / $157,500 for Other Taxpayers
You qualify for an income tax deduction equal to 20% of your trade or business income if:
- You operate the trade or business as a sole proprietor, LLC owner, partner in a partnership, or S corporation shareholder, and
- Your taxable income for the year from all sources after deductions is below $315,000 (MFJ), or $157,500 (Other Taxpayers).
- The additional limitations based on wages paid or depreciation do not apply at all to taxpayers in this taxable income range.
Taxable income between $315,000 - $415,000 (MFJ) or $157,000 - $207,500 for other taxpayers
If your annual taxable income is over $315,000 but under $415,000, or over $157,000 but under $207,500, the deduction is phased out for specified service, trade or business but not for real estate.
Taxpayers in the taxable income phase-out range should consult their tax professional. There is a combination of wage and depreciation calculations which act to limit the amount of the Sec. 199A deduction. There is insufficient space in this article to adequately explain the limitations to taxpayers in this taxable income range.
Taxable Income Above $415,000 (MFJ) / $207,500 (Other Taxpayers)
If your annual taxable income is over $415,000 (MFJ), or $207,500 (Other Taxpayers), you will not be eligible for the Sec. 199A deduction for a specified service, trade or business but will be entitled to a pass-through deduction of up to 20% of the net rental activity income. However, the deduction is limited by the greater of
- 50% of the applicable share of the W-2 employee wages paid by the rental business, or
- 25% of the W-2 wages paid by the business, PLUS 2.5% of the original purchase price of the qualified real property
How will Decisions about Deductions Impact the Sec. 199A Deduction?
Increased and Expanded Section 179 Expensing
Starting in 2018, the Section 179 maximum is increased to $1 million. The $1,000,000 amount is reduced (but not below zero) by the amount by which the cost of property placed in service during the year exceeds $2,500,000. The Section 179 deduction has been expanded to include personal property used in real estate rental activities. If expenses increase and net income is decreased due to an election to expense certain purchases, the Sec. 199A will be limited.
100% Bonus Depreciation Through 2022
Bonus depreciation can be used for real property improvements such as landscaping or grading, and other components that have a depreciation period of 20 years or less. Bonus depreciation can be used to fully deduct in one year the cost of personal property used in rental activities, such as appliances, laundry equipment, gardening equipment, and furniture. Bonus depreciation does not apply to the cost of buildings or major building components with depreciable lives of 20 years or more. Like the Section 179 deduction, an increase in depreciation will decrease net income and the Sec. 199A deduction.