The Tax Cuts and Jobs Act (TCJA) added a new tax deduction for owners of pass-through entities – a 20% deduction of qualified business income (QBI) from a qualified trade or business. In the past, rental income was considered passive income and not business income. Beginning in 2018, rental income will receive the same preferential tax treatment as qualified business income. QBI includes only income associated with business activity conducted in the United States. To better understand the new deduction, let’s look at some examples.
Taxable Income Below the Threshold
If your client’s taxable income is below $315,000 (married filing jointly) or $157,500 (all other filers), the QBI deduction is the lesser of 20% of your rental income or 20% of their taxable income.
Let’s say your client has $100,000 of rental income, which is reported on Schedule E. They file single, so the standard deduction is $12,000.
Taxable Income: $100,000 – $12,000 =$88,000
QBI deduction is the lesser of:
20% of the taxable income at $88,000 (20%) = $17,600
20% of the rental income at $100,000 (20%) = $20,000
QBI deduction is $17,600. After their QBI deduction, their new taxable income is:
$88,000 – $17,600 = $70,400
Their federal income tax is $70,400 (22%) = $15,488
Without the QBI deduction, their tax would be $88,000 (24%) = $21,120
Net Operating Income
The QBI deduction applies to the aggregate income or loss of your client’s rental activity, not to each individual property. If they have three rentals that produce a net operating loss of $7,500, they are not eligible for the deduction even if one of the three rentals produce a net operating income.
Taxable Income Above the Threshold
If your client’s taxable income is above $315,000 (married filing jointly) or $157,500 (all other filers), the calculation gets a little more complicated.
QBI deduction is the lesser of:
20% of their net operating income or
the greater of 50% of the W-2 wages with respect to the qualified trade or business or
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.
Let’s say your client has $250,000 of net rental income. Their QBI deduction should be $50,000 (20% of $250,000). However, since their taxable income is above the threshold for single filers ($157,500 to $207,500), the wages and wage-and-property tests must be applied to see if the QBI deduction is reduced.
During the course of running their real estate business, they paid $50,000 in wages to a property manager and the original depreciable basis of the rental properties is $1,000,000.
We need to calculate the greater of:
$50,000 (50%) = $25,000
$50,000 (25%) + $1,000,000 (2.5%) = $37,500
$37,500 is the greater number. Now, let’s calculate the lesser of $50,000 or $37,500. Their QBI deduction is $37,500.
Qualified property is any tangible depreciable property that meets the following criteria:
- It’s held by, and available for use in, the qualified trade or business at the end of the taxable year
- It’s used to produce QBI at some point during the taxable year
- Its depreciable period doesn’t end before the close of the taxable year
When calculating the QBI deduction for your client’s net rental income, make sure to aggregate the net operating income and net operating loss of your properties. You will not receive a deduction if you have a net loss. Stay tuned for more guidance from the IRS.
About Latino Tax Pro
The Latino Tax Professionals Association (LTPA) is a professional trade association dedicated to excellence in the field of tax preparation and related services. LTPA’s national convention, Latino Tax Fest, attracts thousands of solopreneurs to Las Vegas every summer for 3 days of networking, learning, and fun. For more information visit www.latinotaxfest.com.
Author Bio: Antonio Martinez is the VP of Business Development for LTPA. In 2004 Tony earned a full-ride scholarship to the University of California, Berkeley. Tony majored in Engineering and was involved in various leadership and volunteer roles. Upon graduation, Tony joined the LTPA with a goal of building a national brand. As VP of Business Development, Tony has led the exponential growth of the organization and organized various events throughout the country. In 2014 Antonio became an Enrolled Agent with the goal of representing immigrant taxpayers before the IRS.