The new 20% deduction for “pass-through” business owners under the Tax Cuts and Jobs Act is raising many questions from owners of real estate-related businesses. Can these owners qualify for this important deduction, and under what conditions?
For most pass-through business owners (such as owners of LLCs, Subchapter S corporations, and partnerships), the deduction is the lessor of (1) the “combined qualified business income” of the taxpayer, or (2) 20% of the excess of taxable income over the sum of any net capital gain. The term “combined qualified business income” is then defined as the lessor of (A) 20% of the business owner’s “qualified business income” (QBI) or (B) the greater of (a) 50% of the W-2 wages of the business allocable to the owner or (b) 25% of the W-2 wages of the business plus 2.5% of the unadjusted tax basis in property of the business allocable to the business owner. This last provision was inserted in the new law by Congress to give real estate owners this potential new tax break as well, or at least a portion of it. Owners of real estate-related businesses may be able to receive some benefit from the deduction, even if the business does not have employees (an important limit to other businesses).
For owners of real estate, the business must be considered a “qualified trade or business”. Presumably, this definition includes owners of rental apartment buildings and multiple rental properties, but what about the owner of a vacation home he may periodically rent (reported on a Schedule E on his 1040)?What about an owner of a leased commercial building under a “triple net lease”, and where the owner really does nothing more than collect the rent each month? For now, it not known whether these real estate owners may qualify for the deduction.
If an owner of real estate qualifies for the deduction, what would be the amount of the deduction? The potential deduction is 20% of the taxable income or profit from the real estate business, but is limited to factors including W-2 wages paid to employees of the business and the “unadjusted basis” of “qualified property” held by the business. For many real estate-related businesses, who do not have employees or at least a significant number of employees, the key factor for real estate businesses is the “unadjusted basis” of “qualified property”.
The term “qualified property” means tangible property subject to depreciation held by the business at the end of a year and used any time during the year in the production of QBI. This includes both real and personal property, but not inventory or land (neither of which can be depreciated) or intangible property (patents, etc.). And, “unadjusted basis” means original cost of the property, without depreciation. The main limit here, however, is a condition that the property must also have a “depreciable period which has not [yet] ended before the close of the taxable year” in which the 20% pass-through deduction is sought by the business, and where the term “depreciable period” is specially defined to mean the first tax year in which the property was first placed in service and ending on the later of (A) 10 years, or (B) the last year of the applicable non-accelerated depreciation recovery method for the property (e.g. 5 years for equipment and up to 39 years for buildings).
The thrust of these limitations is that if property is owned by a real estate related business, but it is old property – i.e. older than 10 years or where its depreciable life has otherwise expired (using non-accelerated depreciation lives) – this property is not “qualified property”, and therefore cannot be used by a business to determine its QBI and the amount of the 20% pass-through deduction. However, a reading of the “qualified property” definition, including the “depreciable period” limits, indicates that if a business owns depreciable property which is less than 10 years old or the applicable depreciable life of the property has not yet expired, this property can then be used to calculate QBI and the 20% deduction. Moreover, this property can continue to be added to the QBI calculation for the longer of its depreciable live or 10 years.
- John owns a 20-unit residential apartment building through an LLC. The apartment building was constructed and furnished in 2012. The original cost of the land was $200,000, the building cost was $1,000,000 to construct, and the fixtures, furnishings and equipment in the building cost another $400,000. The building has a non-accelerated depreciable life of 39 years and the equipment has a useful life of 5 years. In 2018, the LLC has a taxable profit of $300,000. Initially, only the $1.4 million cost of the building and other personal property potentially qualifies; the land does not. The potential 20% pass-through deduction is $60,000 for John (20% x $300,000); however, it is limited to 2.5% of the $1.4 million building and equipment cost, or $35,000. Both the cost of the building and the equipment qualifies, because each asset was owned for the longer of its depreciable life or 10 years as of 2018 – the year John seeks his 20% pass-through deduction.
- Same facts, except the apartment building was constructed in 2005 and the fixtures, furnishings and equipment were all added that year as well. Here now, only the building cost qualifies for the deduction calculation and not the other personal property because, as of 2018, the fixtures, furnishings and equipment is all older than 10 years or its depreciable life has otherwise expired. Thus, the $1 million building cost qualifies, 2.5% of $1 million is $25,000 and John’s potential $60,000 20% pass-through deduction is limited now to $25,000.
Owners of real estate-related businesses may potentially qualify for the new 20% pass-through deduction, but the deduction may be limited to 2.5% of the cost of the owner’s allocable share of depreciable real and personal property and where the cost of these assets may be included only during the longer of the useful life of each asset or 10 years.