What Owners of Real Estate and Insurance Brokerages and Agencies Need to Know about the New Section 199A Qualified Business Deduction
by Michelle Gearity
After the passage of the Tax Cuts and Jobs Act of 2017, there has been a lot of discussion about the complexities of the new qualified business deduction for passthrough entity owners – Section 199A (the “Qualified Business Deduction” or “20% Deduction”). Considering that passthrough entities (LLCs, general and limited partnerships, S-corporations, and sole proprietorships) are the legal structure commonly used by owners of real estate and insurance brokerages and agencies, we have put together the following list of items that they should consider this filing season.
Owners of Real Estate and Insurance Brokerages and Agencies Can Qualify for the 20% Deduction.
When the TCJA was first enacted, it was unclear as to whether owners of real estate and insurance brokerages and agencies were eligible for the 20% deduction. The 199A proposed regulations released in August 2018, and IRS Publication 535, confirm that owners of real estate and insurance brokerages and agencies can qualify for the 20% deduction.
The 20% Deduction Applies to Business Taxable Income, and NOT Investment Income, such as Capital Gains.
The 20% Deduction applied to business net income only. The qualifying income is net income after expenses such as guaranteed payments, business expenses and depreciation deductions are accounted for. For owners of S corporations or LLCs treated as partnership, the 20% deduction is roughly equal to 20% of the net business income or rental income reported on the owner’s Schedule k-1. The 20% Deduction does not reduce capital gain income such as gains from the sale of real property. Interest income is generally not considered qualifying income unless such income is related to an active trade or business.
The 20% Deduction does not reduce taxable income for purposes of calculating the 3.8% Net Investment Income Tax (NIIT) or Self-Employment Tax purposes (SE Tax).
Owners will need to add back in the 20% Deduction amounts for purposes of calculating their NIIT or SE Tax liabilities.
The 20% deduction Does Not Apply to W-2 Compensation.
The 20% deduction only applies to owners of qualifying businesses, so employees of real estate or insurance brokerages or agencies who do not receive distributions as a member or owner of the brokerage or agency are excluded from taking advantage of the 20% Deduction.
Owners Above Certain Income Thresholds Should Have Employees or Depreciable Property.
Small business owners earning less than $315,000 in annual taxable income for married couples or $157,500 for individuals are entitled to deduct up to 20 percent of their “qualified business income” earned in a qualified trade or business regardless of whether or not the business has W-2 employees or depreciable business property.
However, owners with annual taxable income that exceeds the phaseout thresholds ($415,000 for joint filers and $207,500 for individual filers) are subject to the following wage and basis limitations. The 20% Deduction is limited to the greater of:
1. 50% of the W-2 wages with respect to the qualified trade or business, or
2. The sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property.
The calculation of the wage-basis limitation occurs at the entity level as opposed to 20% qualifying income calculation which is determined at the owner level. In addition, owners may aggregate more than one qualified business provided that they meet certain requirements.
For illustration of how the wage-basis limitation works, consider the following example.
Joe owns a real estate brokerage firm, files jointly, has $600,000 of taxable income from the business. Joe’s firm pays 200,000 in W-2 wages and has no depreciable property. Joe’s wage testing amount is $100,000. Instead of being able to take the full $120,000, which equals 20% of his $600,000 of qualifying income, Joe is limited to a deduction of $100,000 because the wage limitation reduces the 20% deduction to 50% of the W-2 wages paid by his business (50% of $200,000 is $100,000).
Alternatively, let’s say Joe, again filing jointly, owned the same real estate brokerage firm earning $600,000 of taxable income paid $0 in wages (Joe is the sole owner with no employees and receives only guaranteed payments which do not count for purposes of the wage-basis test) and instead owned property with an unadjusted basis of $5,000,000. Under these facts, Joe could take his full 20% Deduction of $120,000 because under the wage-basis test, Joe’s limitation is the greater of 50 % of wages paid (here, $0) or the sum of 25% of the wages paid plus 2.5% of the unadjusted basis of qualified property (25% of $0 + 2.5% of $5,000,000= $125,000). Since Joe’s basis limitation of $125,000 exceeds the full 20% Deduction amount of $120,000, Joe is entitled to his full 20% Deduction of his $600,000 qualifying income, which is $120,000.