For multifamily real estate property investors, the new rental income pass-through tax deduction born as a result of the Tax Cuts and Jobs Act passed in December 2017 could be great news. The new pass-through provision—IRC Section 199A—allows for a deduction of up to 20 percent of qualified business income (QBI) and is scheduled to last through 2025. It could help investors lower estimated quarterly tax payments immediately.
What Is Pass-Through Income?
Pass-through income is revenue that flows through a business to its owner. This income is taxed at the owner level rather than at the corporate level. By forming a pass-through company and reporting rental income on personal tax returns instead of business returns, multifamily property investors can avoid double taxation.
Who Qualifies for the Rental Income Pass-Through Deduction?
The short answer is that an investor who receives business income on which he or she is required to pay personal income tax could qualify for the new pass-through deduction. The long answer is that the investor would need to be classified into one of the following categories to utilize the rental income pass-through: sole proprietor, general partnership, S corp, limited liability company (LLC), limited liability partnership (LLP), or a trust or estate that has an interest in a pass-through business.
It’s important to note that the 20 percent deduction does not apply to personal-service businesses (other than architectural and engineering services) unless the investor earns less than $157,500 if filing single or $315,000 if married and filing jointly. Service businesses that are not eligible include accounting, health, law, consulting, financial services, brokerage services, or any business in which the major asset is the skill of one or more employees. If you participate in any of those businesses in addition to real estate investing, you would only be eligible to take the pass-through deduction on the QBI from real estate.
How to Form a Pass-Through Company to Take Advantage of the Rental Income Pass-Through Deduction
To form a rental income pass-through company to save on taxes from your real estate investments, you should first find an experienced tax professional to review your overall tax situation and make recommendations based on your unique position.
A trusted professional will explain that as an owner of multifamily real estate, you generate real estate income, which is QBI in the eyes of the IRS. You receive this income regardless of your business structure, but how you structure your business will determine whether or not you are able to take advantage of the rental income pass-through deduction. You will need to consider how best to structure, and then notify the IRS that you would like to treat your real estate business as either a corporation, partnership, or separate entity by filing Entity Classification Election form 8832.
Lastly, be sure to keep separate income statements for the businesses in which you are involved. You will need to show your tax professional and the IRS exactly how much of your multifamily real estate income flowed through your pass-through company to be able to take the pass-through deduction.
How Much Can You Deduct?
The answer to this question, like so many other tax-related questions, is it depends. While you can deduct up to 20 percent of QBI that goes through a pass-through company, the total amount you can deduct depends on both the QBI and your adjusted gross income (AGI) for a given year. QBI is calculated per business not per taxpayer, so, in theory, an investor could qualify for the pass-through deduction multiple times through multiple business ventures. Your QBI is your net income (income minus expenses) from a given income stream. It can include income from self-employment, your business, rental properties, partnerships, a real estate investment trust (REIT), or a qualified cooperative. QBI does not include capital gains, dividend income, interest income, employee wages, or income from outside the U.S.
For example, if your multifamily property income equals $200,000 and your expenses equal $50,000, then your QBI for the year would be $150,000 and your pass-through deduction (20%) would equal $30,000 for that given year.
If your AGI is over $207,500 (if filing single) or over $414,000 (if filing jointly), you can still claim the rental income pass-through deduction, but you are limited by the larger of the two following amounts: half of allocable W-2 wages that are paid by your business or one-fourth of allocable W-2 wages plus 2.5 percent of taxpayer’s allocable share of the unadjusted tax basis of the qualified business property immediately after acquisition.
The new tax law includes several advantages for real estate owners. Taking the above steps will help you learn whether or not you can take advantage of IRC Section 199A by forming a rental income pass-through company to save on taxes resulting from your real estate investments.
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