As part of the Tax Cuts and Jobs Act (TCJA), a new deduction was created as an offset to “qualified business income” (QBI) designed to reduce the tax burden of business owners. This is the new 20 percent tax deduction (199A deduction) of qualifying trade or business income for owners of partnerships, S corporations and sole proprietors. When this section of the law was originally passed there were many unanswered questions for the real estate industry some of which have now been favorable answered by the proposed regulations.
Most professional service businesses (accounting, legal, health, actuarial science, performing arts, financial, investment management and brokerage services) are excluded from benefitting from this deduction once their income exceeds certain levels by the law as they are identified as “specified services trades or businesses” (SSTB’s). Two professional service businesses connected to the real estate industry, architecture and engineering, were exempted from the definition of an SSTB by the TCJA allowing them to benefit from this new deduction. At the time the TCJA was enacted, it appeared that real estate and insurance brokers would be excluded from this deduction since SSTB’s include brokerage services. However, the proposed regulations narrowly defined brokerage services to only include brokering of financial investments and specifically excluded real estate and insurance brokers and agents from this definition. Additionally, it was unclear whether or not a real estate management company would be considered to be in the trade or business of investment management and therefore be an SSTB. The proposed regulations cleared this up by giving real estate management as an example of a business not considered to be engaged in investment management.
As part of this guidance the IRS did provide an anti-abuse provisions to prevent taxpayers from incorrectly trying to take advantage of the tax law. The first relates to a situation where an employee now desires to be treated as an independent contractor to take advantage of the 199A tax deduction. The regulations provide that former employees are presumed to still be employees even if subsequently treated as an independent contractor. The IRS provides a number of tests and factors to consider if a worker is an independent contractor or employee which should be considered by an employer before changing a worker’s classification.
A second potentially friendly section of the proposed regulations address an election to aggregate certain trades or businesses together for purposes of the Section 199A deduction. Generally, a taxpayer must calculate the 199A deduction for each trade or business they own. A taxpayer’s ability to claim the full 20 percent deduction may be limited if the trade or business had not paid enough in wages or owned enough qualifying property during the year. The proposed regulations now provide for an election to aggregate qualifying businesses together for purposes of calculating the 199A deduction. To qualify for aggregation, two or more businesses must have:
- 50 percent or more common ownership,
- Have the same tax year,
- None can be SSTB’s, and
- Must meet two of the three following criteria:
- Products/services of the businesses are the same or customarily offered together,
- Share facilities or have significant centralized business elements, or
- Be operated in coordination with each other
Aggregation may be beneficial to group multiple rental real estate businesses with a management company to combine the overall tax attributes (wages and qualifying property) for purposes of calculating the 199A deduction. Once an aggregation election is made by a taxpayer, they must continue to aggregate the businesses going forward.
While the guidance provided by the IRS was favorable to the real estate industry it has not answered all important questions including if there will be special treatment granted to real estate professionals or provide guidance for what level of activity a rental property must achieve to be considered a trade or business for purposes of this deduction. It is also important to note that these are proposed tax regulations and are still subject to change when the final regulations are issued. For additional information regarding the 199A deduction click here.