How Rental Income Will Be Taxed In Years 2019+

Tax reform will change the way rental income is taxed to landlords beginning in 2018. Under current law, rental income is classified as "passive income" and that income simply passes through to the owner's personal tax return and they pay ordinary income tax on it. Beginning in 2018, rental income will be eligible to receive the same preferential tax treatment as the "qualified business income" (QBI) for small business owners.

20% Deduction

Starting in 2018, taxpayers with qualified business income (including rental income), may be eligible to take a tax deduction up to 20% of their QBI. Determining whether or not you will be eligible to capture the full 20% deduction on your rental income will be based on your total taxable income for year. The taxable income thresholds are as follows:Single filers: $157,500Married filing joint: $315,000"Total taxable income" is not your AGI (adjusted gross income) and it's not just income from your real estate business or self-employment activities. It's your total taxable income less some deductions. The IRS has yet to provide us with full guidance on the definition of "total taxable income". For example, let's assume you have three rental properties owned by an LLC and you net $50,000 in income from the LLC each year. But your wife is a lawyer that makes $350,000 per year. Your total taxable income for the year would be $400,000 landing you above the $315,000 threshold.

Below The Income Threshold

If your total taxable income is below the income thresholds listed above, the calculation is very easy. Take your total QBI and multiply it by 20% and that's your tax deduction.

Above The Income Threshold

If your total taxable income is above the thresholds, the calculation gets more complex. If you exceed the income thresholds, your deduction is the LESSER of:

1. 20% of QBI

1. The GREATER OF:

• 50% of W-2 wages paid to employees

• 25% of W-2 wages paid to employees PLUS 2.5% of the unadjusted asset basis

The best way to explain the calculation is by using an example. Assume the following:

• I bought a commercial building 3 years ago for $1,000,000

• I have already captured $100,000 in depreciation on the building

• After expenses, I net $150,000 in income each year

• The LLC that owns the property has no employees

• I'm married

• I own a separate small business that makes $400,000 in income

Since I'm over the $315,000 total taxable income threshold for a married couple filing joint, I will calculate my deduction as follows:The LESSER of:

1. 20% of QBI = $30,000 ($150,000 x 20%)

1. The GREATER of:

• 50% of W-2 wage paid to employees = $0 (no employees)

• 25% of W-2 wages page to employees plus 2.5% of unadjusted basis

(25% of wages = $0) + (2.5% of unadjusted basis = $25,000) = $25KIn this example, my deduction would be limited to $25,000. Here are a few special notes about the calculation listed above. In the 11th hour, Congress added the "2.5% of unadjusted basis" to the calculation. Without it, it would have left most landlords with a $0 deduction. Why? Real estate owners typically do not have W-2 employees, so 50% of W-2 wages would equal $0. Some larger real estate investors have "property management companies" but they are usually set up as a separate entity. In which case, the W-2 income of the property management company would not be included in the calculation for the QBI deduction. If you are someone who owns a property or properties and is need of a Property management company to help you with organizing and operating your property, then doing research in your general area to find a real estate company that can help you with that is important.Another special note, 2.5% is based on an unadjusted basis and it's not reduced by depreciation. However, the tangible property has to be subject to depreciation on the last day of the year to be eligible for the deduction. Meaning, even though the 2.5% is not reduced for the amount of depreciation already taken on the property, the property must still be in the "depreciation period" on the last day of the year to be eligible for the QBI deduction.Tony Nitti, a writer for Forbes, also makes the following key points:

• The depreciable period starts on the date the property is placed in service and ends on the LATER of:

- 10 years, or- The last day of the last full year in the asset's "regular" (not ADS) depreciation periodMeaning, if you purchase a non-residential rental building that is depreciated over 39 years, the owner can continue to capture the depreciation on the building but that will not impact the 2.5% unadjusted basis number for the full 39 years of the depreciation period.

• Any asset that was fully depreciated prior to 2018, unless it was placed in service after 2008, will not count toward the basis.

• Shareholders or partners may only take into consideration for purposes of applying the limitation 2.5% his or her allocable share of the basis of the property. So if the total basis of commercial property is $1,000,000 and you are a 20% owner, you basis limitation is $1,000,000 x 20% x 2.5% = $5,000

Phase-In Of The Threshold

The questions I usually get next is: "If I'm married and our total taxable income is $320,000 which is only $5,000 over the threshold, do I automatically have to use the more complex calculation?" The special calculation "phases in" over the following total taxable income thresholds:Single filers: $157,500 - $207,500Married filing joint: $315,000 - $415,000I won't get into the special phase-in calculation because it's more complex than the special "above the income threshold" calculation that we already walked through but just know that it will be a blend of the straight 20% deduction and the W-2 & 2.5% adjusted basis calculation.

Qualified Trade or Business Requirement

In August 2018, the IRS came out with further clarification of how the QBI deduction would apply to real estate. In order to qualify for the QBI deduction for real estate income, your real estate holdings have to qualify as a "trade or business". The definition of a trade or business for QBI purposes deviates slightly from the traditional IRS definition. There is a safe harbor that states if you spend more than 250 hours a year working on that business it will qualify for the deduction.There are a few items to consider in the 250 hour calculation. So called "drive bys" where the owner is spending time driving by their properties to check on them does not count toward the 250 hours. If you have a property management company, the hours that they spend managing your propoerty can be credited toward your 250 hour requirement. However, the property management company has to provide you with proper documentation to qualify for those credited hours.

Consult Your Accountant

I'm a Certified Financial Planner®, not an accountant. I wrote this article to give real estate investors a broad view of what tax reform may have instore for them in 2018. If you own rental property, you should be actively consulting with our accountant through the year. As the IRS continues to release guidance regarding the QBI deduction throughout 2018, you will want to make sure that your real estate holdings are positioned properly to take full advantage of the new tax rules.

About Michael.........

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

How Pass-Through Income Will Be Taxed For Small Business Owners

While one of the most significant changes incorporated in the new legislation was reducing the corporate tax rate from the current 35% rate to a 21% rate in 2018, the tax bill also contains a big tax break for small business owners. Unlike large corporations that are taxed at a flat rate, most small businesses, are "pass-through" entities, meaning that the profits from the business flow through to the business owner's personal tax return and then are taxed at ordinary income tax rates.While pass-through income will continue to be taxed at ordinary income tax rates, many small business owners will be eligible to deduct 20% of their "qualified business income" (QBI) starting in 2018. In other words, some pass-through entities will only be taxes on 80% of their pass-through income.

Pass-through entities include

Sole proprietorships

Partnerships

LLCs

S-Corps

Unanswered Questions

I wanted to write this article to give our readers the framework of what we know at this point about the treatment of the pass-through income in 2018. However, as many accountants will acknowledge, there seems to be more questions at this point then there are answers. The IRS will need to begin issuing guidance at the beginning of 2018 to clear up many of the unanswered questions as to who will be eligible and not eligible for the new 20% deduction.

Above or Below "The Line"

This 20% deduction will be a below-the-line deduction which is an important piece to understand. Tax lingo makes my head spin as well, so let's pause for a second to understand the difference between an "above-the-line deduction" and a "below-the-line deduction".The "line" refers to the AGI line on your tax return which is the bottom line on the first page of your Form 1040. While both above-the-line and below-the-line deductions reduce your taxable income, it's important to understand the difference between the two.

Above-The-Line Deductions

Above-the-line deductions happen on the first page of your tax return. These deductions reduce your gross income to eventually reach your AGI (adjusted gross income) for the year. Above-the-line deductions include:

• Contributions to health savings accounts

• Contributions to retirement plans

• Deduction for one-half of the self-employment taxes

• Health insurance premiums paid

• Alimony paid, student loan interest, and a few others

The AGI is important because the AGI is used to determine your eligibility for certain tax credits and it will also have an impact on which below-the-line deductions you are eligible for. In general, the lower your AGI is, the more deductions and credits you are eligible to receive.

Below-The-Line Deductions

Below-the-line deductions are reported on lines that come after the AGI calculation. They are comprised mainly of your “standard deduction” or “itemized deductions” and “personal exemptions” (most of which will be gone starting in 2018). The 20% deduction for qualified business income will fall into this below-the-line category. It will lower the income of small business owners but it will not lower their AGI.

However, it was stated in the tax legislation that even though the 20% qualified business deduction will be a below –the-line deduction it will not be considered an “itemized deduction”. This is a huge win!!! Why? If it’s not an itemized deduction, then small business owners can claim the 20% qualified business income deduction and still claim the standard deduction. This is an important note because many small business owners may end up taking the standard deduction for the first time in 2018 due to all of the deductions and tax exemptions that were eliminated in the new tax bill. The tax bill took away a lot of big deductions:

• Capped state and local taxes at $10,000 (this includes state income taxes and property taxes)

• Eliminated personal exemptions ($4,050 for each individual) (Eliminated in 2018)

  • Family of 4 = $4,050 x 4 = $16,200 (Eliminated in 2018)

• Miscellaneous itemized deductions subject to 2% of AGI floor (Eliminated in 2018)

Restrictions On The 20% Deduction

If life were easy, you could just assume that I'm a sole proprietor, I make $100,000 all in pass-through income, so I will get a $20,000 deduction and only have to pay tax on $80,000 of my income. For many small business owners it may be that easy but what's a tax law without a list of restrictions.The restriction were put in place to prevent business owners from reclassifying their W2 wages into 100% pass-through income to take advantage of the 20% deduction . They also wanted to restrict employees from leaving their company as a W2 employee, starting a sole proprietorship, and entering into a sub-contractor relationship with their old employer just to reclassify their W2 wages into 100% pass-through income.

S-Corps

Qualified business income will specifically exclude "reasonable compensation" paid to the owner-employee of an S-corp. While it would seem like an obvious reaction by S-corp owners to reduce their W2 wages in 2018 to create more pass through income, they will still have to adhere to the "reasonable compensation" restriction that exists today.

Partnerships & LLCs

Qualified business income will specifically exclude guaranteed payments associated with partnerships and LLCs. This creates a grey area for these entities. Partnerships do not have a “reasonable compensation” requirement like S-corps since companies taxed as partnerships are not allowed to pay W2 wages to the owners. Also the owners of partnerships are not required to take guaranteed payments. My guess is, and this is only a guess, that as we get further into 2018, the IRS may require partnerships to classify a percentage of a owners total compensation as a “guaranteed payment” similar to the “reasonable compensation” restriction that S-corps currently adhere too. Otherwise, partnerships can voluntarily eliminate guaranteed payments and take the 20% deduction on 100% of the pass-through income.

This may also prompt some S-corps to look at changing their structure to a partnership or LLC. For high income earners, S-corps have an advantage over the partnership structure in that the owners do not pay self-employment tax on the pass-through income that is distribution to the owner over and above their W2 wages. However, S-corp owners will have to weigh the self-employment tax benefit against the option of changing their corporate structure to a partnership and potentially receiving a 20% deduction on 100% of their income.

Sole Proprietors

Sole proprietors do not have "reasonable compensation" requirement or "guaranteed payments" so it would seem that 100% of the income generated by sole proprietors will count as qualified business income. Unless the IRS decides to enact a "reasonable compensation" requirement for sole proprietors in 2018, similar to S-corps. Before everyone runs from a single member LLC to a sole proprietorship, remember, a sole proprietorship offers no liability barrier between the owner and liabilities that could arise from the business.

Income Restrictions

There are limits that are imposed on the 20% deduction based on how much the owner makes in “taxable income”. The thresholds are set at the following amounts:

Individual: $157,500

Married: $315,000

The thresholds are based on each business owner’s income level, not on the total taxable income of the business. We need help from the IRS to better define what is considered “taxable income” for purposes of this phase out threshold. As of right now, it seems that “taxable income” will be defined as the taxpayer’s own taxable income (not AGI) less deductions.

If the owner’s taxable income is below this threshold, then the calculation is a simple 20% deduction of the pass-through income. If the owner’s taxable income exceeds the threshold, the qualified business deduction is calculated as follows:

The LESSER of:

20% of its business income OR 50% of the total wages paid by the business to its employees

Let’s look at this in a real life situation. A manufacturing company has a net profit of $2M in 2018 and pays $500,000 in wages to its employees during the year. That company would only be able to take the qualified business income deduction for $250,000 since 50% of the total employee wages ($500,000 x 50% = $250,000) are less than 20% of the net income of the business ($2M x 20% = $400,000).

This creates another grey area because it seems that the additional calculation is triggered by the taxable income of each individual owner but the calculation is based on the total profitability and wages paid by the company. For the owners that required this special calculation for exceeding the threshold, how is their portion of the lower deduction amount allocated? Multiplying the lower total deduction amount by the percent of their ownership? Just more unanswered questions.:

Restrictions For "Service Business"

There will be restrictions on the 20% deduction for pass-through entities that are considered a "service business" under IRC Section 1202(e)(3)(A). The businesses specifically included in this definition as a services business are:

• Health

• Law

• Accounting

• Actuarial Sciences

• Performing Arts

• Consulting

• Athletics

• Financial Services

• Any other trade or business where the principal asset of the business is the reputation or skill of 1 or more of its employees

In a last minute change to the regulations, to their favor, engineers and architects were excluded from the definition of “service businesses”.

This is another grey area. Many small businesses that fall outside of the categories listed above will undoubtedly be asking the question: “Am I considered a service business or not?” Outside of the industries specifically listed in the tax bill, we really need more guidance from the IRS.

If you are a “services business”, when the tax reform was being negotiated it looked like service businesses were going to be completely excluded from the 20% deduction. However, the final regulations were more kind and instead implemented a phase out of the 20% deduction for owners of service businesses over a specified income threshold. The restriction will only apply to those whose “taxable income” exceeds the following thresholds:

Individual: $157,500

Married: $315,000

If you are a consultant or owner of a services business and your taxable income is below these thresholds, it would seem at this point that you will be able to capture the 20% deduction for your pass-through income. As mentioned above, we need help from the IRS to clarify the definition of “taxable income”.

Phase Out For Service Businesses

The amounts listed above: $157,500 for individual and $315,000 for a married couple filing joint, are where the thresholds for the phase out begins. The service business owners whose income rises above those thresholds will phase out of the 20% deduction over the next $50,000 of taxable income for individual filers and $100,000 of taxable income for married filing joint. This means that the 20% pass-through deduction is completely gone by the following income levels:

Individual: $207,500

Married: $415,000

Any taxpayer’s falling in between the threshold and the phase out limit will receive a portion of the 20% deduction.

Since the thresholds are assessed based on the taxpayer’s own taxable income and not the total income of the business, a service business could be in a situation, like in an accounting firm, where the partners with the largest ownership percentage may not qualify for 20% deduction but the younger partners may qualify for the deduction because their income is lower.

Tax Planning For 2018

It's an understatement to say that most small business owners will need to spend a lot of time with their accountant in the first quarter of 2018 to determine the best of course of action for their company and their personal tax situation.While we are still waiting for clarification on a number of very important items associated with the 20% deduction for qualified business income, hopefully this article has provided our small business owners with a preview of things to come in 2018.

Disclosure: I'm a Certified Financial Planner® but not an accountant. The information contained in this article was generated from hours and hours of personal research on the topic. I advise each of our readers to consult with your personal tax advisor for tax advice.

About Michael.........

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.