By now, you have read and heard plenty about the new tax law, and you likely have an opinion about it formed mostly by your political leanings. It’s either the best thing since sliced bread or it only benefits the top 1%, depending on your political party affiliations.
In this article I will separate the wheat from the chaff to explain what we have been seeing in our comparisons with the old tax law for some of our clients. The reform was huge, so I will limit this article to just a few critical elements for most investors.
Pass the SALT (Reduced Deductibility of State and Local Taxes)
Most of our clients are seeing a modest net reduction in taxes for 2018. However, for those unlucky souls with a combination of both, a) more than $24,000 in itemized deductions, and, b) more than $10,000 in combined property and state income taxes, their net tax bills have been going up a little. For these individuals and couples, we have not seen significant tax increases, primarily because under the former tax law, the Alternative Minimum Tax (AMT) limited their ability to deduct state and local taxes beyond a certain point, anyway.
New 20% Deduction for Income from Small Businesses & Self Employed
For individuals and couples, the big and unexpected whopper of a tax cut came in the form of a new 20% deduction for “Qualified Business Income” self-employed and small business owners.
Under IRS Code Section 199A, if you earn “Qualified Business Income” (or QBI) through a small business, including self-employment, you may be entitled to a deduction of up to 20% of your taxable income. This new rule is extremely complicated and you should definitely not make any plans about spending your tax cut before you speak with a qualified tax professional. There are many questions still to iron out but here are the broad strokes as they are currently understood:
For owners of actively managed rental real estate (i.e. you spend more than 750 hours a year managing it), and some non-service businesses, it appears you can qualify for a deduction of up to 20% of your net rental income at any income level, subject to the following limitations:
- If your taxable income is less than $157,500 (single filer) or $315,000 (married filing jointly), you can deduct 20% of QBI.
- If your taxable income is greater than $207,500 (single) or $415,000 (MFJ), your QBI deduction is limited to:
- 50% of the W-2 wages paid by the business, or
- 25% of the W-2 wages paid plus 2.5% of the original acquisition price of the assets of the business.
Because many owners of rental real estate do not have any W-2 employees, the limitation on your ability to deduct 20% of QBI is going to be the purchase price of the business real estate you own. If you own real estate that cost you $500,000, 2.5% of that amount is $12,500, so your 20% deduction will be limited to $12,500. That could amount to federal income tax savings of as much as $5,100, and possibly more if California adopts these changes for state income tax purposes. Also important to note:
- If your taxable income is between the levels described in #1 and 2 above, your QBI deduction is phased out.
- If you are considered a “passive” owner of rental real estate, you do not qualify for the 20% QBI deduction.
Owners of “Specified Services Businesses”. If your business is on a list of “specified” service businesses (including doctors, lawyers, financial advisors and accountants, but notably excluding architects and engineers, as well as other businesses where the principal asset of such trade or business is the reputation or skill of one or more of its owners or employees), then your ability to take the deduction is limited as follows:
- If your taxable income is less than $157,500 (single filer) or $315,000 (married filing jointly), you can deduct 20% of QBI.
- If your taxable income is greater than $207,500 (single) or $415,000 (MFJ), you are not eligible for the QBI deduction.
Clear as mud, right? We think so too. If you are an owner of a business described above, be sure to speak with a qualified tax professional as early as possible this year. There appear to be strategies that you can consider adopting, including creating an S-corporation or opting to have your LLC be taxed as an S-corp. that can have a pretty dramatic effect in getting you a larger QBI deduction. This will be a year when great CPAs will be worth their weight in gold in helping clients figure out the intricacies of this new deduction. If you don't have a CPA to assist you, please contact us for a referral.
We are also available to help you figure out your options and calculate how the new tax law will impact your situation, so give us a call.
Feel free to pass this information on to friends and family who have rental real estate or own a small business!
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