The New 20% Pass-Through Deduction and You

[Thomas Jones]

The IRS issued more guidance on Wed, Aug 8th on the new Sec. 199A 20% pass-through deduction. But many taxpayers are wondering does this apply to real estate activities as well.

The 20% deduction applies to Qualified Business Income (QBI) from a "trade of business." Capital gains, interest income, and dividends (except from a REIT or PTP) are explicitly not included. The proposed regs are silent as to whether a rental activity is a "trade or business" but instead relies on Sec 162. Sec 163(j)(7)(A) is pretty clear that rental income does not qualify as income from a trade or business, so for purposes of the 20% deduction my guess is it's not likely to qualify either. This also likely includes those who qualify for real estate professional treatment on their taxes (i.e. those with 750+ hours of substantial involvement in real estate).

However, there are a couple areas that may apply to those involved in real estate. The CFR 1.199A mentions:

• “Both active and passive owners of a trade or business may be entitled to a section 199A deduction”
• “The proposed regulations extend the definition of trade or business for purposes of section 199A beyond section 162 in one circumstance. Solely for purposes of section 199A, the rental or licensing of tangible or intangible property to a related trade or business is treated as a trade or business if the rental or licensing and the other trade or business are commonly controlled…”

So what likely qualifies?

1. Management companies – Sometimes taxpayers with lots of rentals consider forming a separate management company. Rentals pay management fees to the management company, which operates as a normal trade or business.
2. Some operators – Depending on the structure of a real estate syndicate, if the operator receives a management fee or guaranteed payment, then the operator would have Qualified Business Income (QBI) for taking the 20% pass-through deduction. However, profits interest, carry, capital gains, and pass-through rental income do not qualify as QBI. Also, in these instances, if the operator was taxed as a partnership or S-Corp, then there would have to be an allocation to determine the applicable amount of QBI.
3. Real estate used in a business/self-rentals – Often business owners hold real estate used by a business in a different entity and capitalize that holding entity through a self-rental agreement between the business and holding entity. Self-rentals are subject to unique rules on net rental income and losses, but there are provisions that allow for the activities to be aggregated. So a business owner would include net rental income from the holding entity with the QBI from the business in calculating their 20% deduction under the aggregation rules.
4. “Box 1” passive investors – Passive investors who receive a K-1 with income in Box 1 “Ordinary business income (loss)” will have QBI.
5. Realtors and other professionals – Definitely a trade or business. However, these individuals or businesses are considered Specified Service Trade or Businesses (SSTB) and QBI from a SSTB gets phased-out for high income taxpayers.

The rules are complex and there’s a lot not even mention. Taxpayers with foreign assets, multiple businesses, prior year Net Operating Losses, or reasonable officer compensation requirements have even more complex rules involved.