If you’re a real estate investor, you’ve probably already wondered whether you get a real estate investor Sec. 199A deduction. (You do.) And then also how the deduction works. (Er, it’s complicated.)
Accordingly, in this post I explain how the deduction works. And when it doesn’t work. I’ll also discuss why some people think you don’t get the deduction—and why other folks (like me) disagree.
How Real Estate Investor Sec. 199A Deduction Works
Starting in 2018, the Sec. 199A deduction allows taxpayers to add a tax deduction to a return tentatively equal to 20% of their qualified business income.
Because qualified business income includes net rental income from real estate investments, real estate investors (even small investors) should get the deduction.
For example, if you make $10,000 a year off of a rental, you would get a $2,000 deduction. And if you make $100,000 a year off of a rental, you would get a $20,000 deduction.
The accounting is more involved that you might at first hope, however. For example, you need to include any depreciation in your accounting. (So you don’t look at cash flow, but at what your tax return shows.)
Further, you don’t include capital gains (such as from the sale of a piece of real estate) in your qualified business income.
Limits on Real Estate Section 199A Deduction
Confusingly, for direct real estate investment folks, tax law limits the size of the actual Sec. 199A deduction a taxpayer gets.
Most of these limitations shouldn’t apply to small real estate investors. Nevertheless, let’s go through them one by one.
First, your real estate Sec. 199A deduction can’t exceed 20% of your taxable income less any capital gains or losses.
For example, suppose your taxable income equals $50,000 and that amount includes no capital gains or losses. Further suppose that your real estate qualified business income equals $100,000.
In this case, you don’t get a deduction equal to 20% of that $100,000. You get a deduction equal to 20% of the $50,000.
Another limit. If your income exceeds $207,500 and you’re single or exceeds $415,000 and you’re married, your real estate Sec. 199 deduction can’t exceed the greater of these calculated amounts:
50% of your W-2 wages from inside the real estate business
25% of your W-2 wages from inside the real estate business plus 2.5% of the original purchase you paid for the depreciable part of the real estate (so everything but the land).
There’s a phase-in range that runs from $157,500 to $207,500 for single taxpayers and from $315,000 to $415,000 for married taxpayers. Within the phase-in range, W-2 wages and depreciable property sort of matter. (See our blog post, Sec. 199A Phase-out Deduction Calculations for details.)
Below the phase-in range, wages and depreciable property don’t matter at all.
But back to the W-2 wages and depreciable property limitations. Suppose your taxable income exceeds $207,500 and you’re single or $415,000 and you’re married and that you owe a property that generates $150,000 a year in rental income.
Tentatively, you get a $30,000 deduction because 20% of $150,000 equals $30,000.
However, that deduction needs to be compared to your “real estate business” wages and your depreciable property.
If you have $40,000 of wages (most real estate investors don’t employ workers for their investments) and the original cost of depreciable part of the real estate investment equals $600,000, you calculate two amounts:
50% of the $40,000 of wages, which equals $20,000
25% of the $40,000 wages plus 2.5% of the $600,000, which equals $25,000
In this case, the 25% of the wages plus 2.5% of the original depreciable property produces a higher value, $25,000. And because that $25,000 is less than the $30,000 tentative Sec. 199A deduction, the investor gets limited to $25,000.
More Details about the Depreciable Assets
The depreciable assets stuff probably doesn’t limit the Sec. 199A deduction in the early years of an investment.
For example, say you buy a $1,000,000 property and calculate the depreciable part (so not the land) equals $800,000.
If you have no wages, the Sec. 199A deduction could get limited to $20,000 or 2.5% of the $800,000. But that’s probably not a real limit.
A $20,000 real estate Sec. 199A deduction would be the deduction you get on $100,000 of rental income (because $20,000 equals 20% of $100,000.)
However as another example, if you fast forward three decades and now your $1,000,000 property is a $3,000,000 property (simply due to average inflation), maybe you do hit the limit. Especially if you’ll fully depreciated the property and paid off the mortgage (which push up the net rental income.)
Three other things to note, too, about the depreciable assets and depreciation stuff.
First, assets are included in the depreciable assets total for either ten years or through the last full year of depreciation—whichever is longer.
For example, some item you depreciate over five years (like maybe appliances) gets included for ten years in the calculations.
And then longer lived assets which usually provide only a partial last year of depreciation probably don’t get included in the calculations for their full depreciable life. A residential 27.5-year property, for example, maybe only gets included for the first 27 calendar year during which you own the property.
A tangential comment… If you really want more detail on the Sec. 199A deduction, you may be interested in our Maximizing Sec. 199A Deductions e-book monograph.
This 90 page monograph goes into detail about how the new tax deduction works using dozens of simple examples, providing dozens of tactics (some simple, some not) that real estate investors and small businesses may need to use to maximize their Sec. 199A deductions.
Second, right now, it’s unclear (at least to me) how taxpayers factor into their qualified business income the part of any real estate profits that represent recaptured depreciation.
I am pretty sure that any gain or loss treated as ordinary income gets included and that any gain or loss treated as capital gain or loss doesn’t get included. I am guessing that unrecaptured Sec. 1250 gain (which is the gain that reflects past depreciation on the building) doesn’t get included.
But we need to wait for more guidance on these details.
Third, you look at the depreciable assets at the end of the year. For example, if you sell your rental property on December 15th and so hold no property on December 31, your depreciable property value equals zero. (This would be something to consider when timing the sale of a property that produces qualified business income if you’re subject to the limitation requirement.)
Trade or Business Requirement
One esoteric wrinkle about all this real estate Sec. 199A deduction bears mentioning–at least in passing.
Lots of tax accountants wonder whether your real estate activity needs to rise above some threshold level in order to qualify for the Sec. 199A deduction.
Without getting too far into the weeds on this, this wondering (maybe worrying is a better label) seems to stem from the requirement for real estate investors who want to avoid paying the Obamacare surtax on their real estate profits. Those folks need to show their participation rises above a threshold level (something we’ve talked about here: real estate investors and the Sec. 1411 net investment income tax) provided in the Treasury’s regulations that define material participation.)
I think casual investors do get the Sec. 199A deduction and for a handful of fuzzy reasons I’m just going to list here:
- The original bill from the House of Representatives seems to pretty explicitly include real estate investors based on the capital investment they made. (This was not the bill Congress in the end passed, but you at least know how the House felt.)
- The House in its reports on its bill talked about sole proprietors including not just Schedule C “active trades and business” ventures and Schedule F “farmers and ranchers” but also Schedule E “rental property investors.”
- The Senate’s version of the Tax Cuts and Jobs Act didn’t explicitly exclude these real estate investors. But here’s the thing: It did explicitly exclude many other “pass-thru” folks.
- Though Sec. 199A largely followed senate’s bill, when the House and Senate mashed up their two bills to come up with the final legislation that ultimately passed, they added the language that connected the deduction to the original cost of depreciable property (discussed above) which mechanically would mean a venture without wages but lots of depreciable property easily qualifies. (That sure sounds like real estate to me.)
- Finally, and maybe most telling, the law Congress passed specifically does let people who passively invest in real estate partnerships and real estate investment trusts (REITs) use the deduction.
The Last Word
A quick final remark: The Sec. 199A deduction doesn’t impact your 2017 tax return. It impacts your 2018 through 2025 tax returns.
Other Related Sec. 199A Deduction Articles
A general primer on the new law (not just for real estate investors): Pass-thru Income Deduction: Top 12 Things Every Business Must Know
If you’re a real estate developer or renovating houses, you may want to peruse this article: S Corporation Shareholder Salaries and Sec. 199A Deduction
Real estate brokers and agents may find this discussion useful: Sec. 199A Pass-thru Deduction and the Principal Asset Disqualification