Part I of this column discussed changes affecting real estate including the pass-through business deduction adopted in new §199A of the Tax Cuts and Jobs Act (Tax Act), Pub. L. No. 115-97 (enacted Dec. 22, 2017). This column expands upon the workings of the pass-through business deduction (pass-through deduction).

Subject to limitations discussed below, the Tax Act provides for a maximum effective tax rate of 29.6 percent on an individual's domestic qualified business income (QBI) from a partnership, S corporation, or sole proprietorship. The reduced maximum rate arises from a 20 percent deduction ([100 percent – 20 percent] x 37 percent top individual marginal rate = 29.6 percent). Thus, a high-income taxpayer with $100,000 of qualifying income would get a deduction of $20,000. The remaining $80,000 of income (after the deduction) would be taxed at 37 percent. The taxpayer would owe $29,600. The taxpayer's effective tax rate is 29.6 percent. Any qualified business losses carry forward to the next tax year and reduce the amount of QBI included in determining the amount of the pass-through deduction for that year. Real estate rental income will qualify for the 29.6 percent rate; long-term capital gain income will continue to be taxable at 20 percent, and short-term capital gain will now be taxable at the maximum 37 percent individual rate. The pass-through deduction for QBI is effective for taxable years beginning after Dec. 31, 2017 and sunsets after Dec. 31, 2025.

Specified services. QBI is net income and gain arising from a qualified trade or business and does not include certain forms of investment income (e.g., capital gain, most dividends, and interest that is not allocable to a qualified trade or business). A qualified trade or business is generally any business other than certain service businesses, referred to as specified service trades or businesses. Specified services include any trade or business involving the performance of services in the fields of health, law, accounting, actuarial service, performing arts, consulting, athletics, financial services, brokerage services, including investing and investment management, trading, or dealing in securities, partnership interests, or commodities. Specified services also include any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its owners or employees. This provision (which has an uncertain meaning) could exclude construction businesses, firms in the building trades, firms that provide maintenance or repair work, hotels or hotel management firms, restaurants, and possibly specialty manufacturers. It seems unlikely that this result was intended, however, the language is very broad.

Since most specified service trades or businesses do not include traditional real estate businesses, a qualified business should include a trade or business of the renting of real property and real estate development. Accordingly, rental income and ordinary income from real estate development should be subject to the new maximum 29.6 percent rate. However, rental income from the triple-net leasing of real estate is not generally considered a trade or business and would not be entitled to the 29.6 percent pass-through rate, unless the real estate is held through a real estate investment trust (REIT).

The calculation of the pass-through deduction is the final calculation that will be made on the taxpayer's tax return. This is because some of the limits of the components of the pass-through deduction are based on taxable income. When the term taxable income is used in §199A, it refers to taxable income that is calculated without regard to the pass-through deduction. The §199A deduction is neither a deduction in computing the adjusted gross income of individual taxpayers nor is it an itemized deduction for those taxpayers. The pass-through deduction is a deduction from taxable income for individual taxpayers who take the standard deduction and for individual taxpayers who itemize their deductions. See generally Code §§1, 4, 199A (new), 701, 1366, 6662A.

Trade or business. Until guidance is issued, a trade or business for purposes of the §199A deduction is likely an “activity conducted on a regular, continuous and substantial basis” (Code §1061(c)(2)) that has the objective of making a profit. A rental activity will have to be carefully evaluated as to whether it constitutes a trade or business. See, e.g., Stanton v. C.I.R., 399 F.2d 326 (5th Cir. 1968), aff'g T.C. Memo 1967-137; Nieman v. C.I.R., T.C. Memo 2016-11 (Jan. 19, 2016).

A single trade or business versus several trades or businesses. It is customary for many real estate owners to conduct business through several entities. For example, a homebuilder may build several developments located in different areas, using a separate pass-through entity for each project. Does this homebuilder have one trade or business or several trades or businesses? Under the passive loss regulations (Reg. §1.469-4(c)(1)), if the homebuilding activities constitute an appropriate economic unit, then they could be a single activity. That test is a facts and circumstances test based upon certain factors including common control, common ownership and interdependence. Reg. §1.469-4(c)(2). The passive activity regulations are not necessarily the primary authority for defining a trade or business, but may provide guidance for making this determination.

A similar decision would have to be made in the case of a real estate professional that builds, owns, and operates apartment houses and commercial buildings. The real estate professional may have a construction company that builds the buildings and a management company that manages the properties after the construction is completed. Each apartment house and commercial building most likely would be owned in separate partnerships that have different partners. The construction company, the real estate management company, each apartment house partnership, and each commercial building partnership are separate activities that would have to satisfy the regular, continuous, and substantial activity trade or business standards.

Calculating the pass-through deduction. As the last column reviewed, the amount of the deduction available to a taxpayer from a partnership, S corporation or sole proprietorship cannot exceed the greater of (a) 50 percent of the taxpayer's share of the W-2 wages paid with respect to the qualified trade or business or (b) the sum of 25 percent of the W-2 wages with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property. Qualified property is defined as depreciable tangible property that is held by and available for use in a qualified trade or business at the close of the taxable year and is used in the production of QBI for the period beginning on the date the property is first placed in service by the taxpayer and ending on the later of (a) the date 10 years after that date or (b) the last day of the last full year of the applicable recovery period that will apply to the property under Code §168 (without regard to Code §168(g)).

The W-2 wage/qualified property limitation does not apply to individuals with taxable incomes at or below $315,000 for married individuals filing jointly or $157,000 for single individuals, but phases-in completely over the next $100,000 or $50,000, as applicable, of taxable income. In addition, REIT ordinary dividends are not subject to the limitation. Master limited partnership income is eligible for the deduction under special rules.

Example 1 illustrates a real property investment with no employees. The 25 percent of the W-2 wages plus 2.5 percent of unadjusted basis test is beneficial to the owners of a pass-through business with no employees engaged in a qualified trade or business with an investment in depreciable real property. Taxpayer (T) with a $10M qualified property investment is eligible for a deduction of up to $250,000 (2.5 percent of $10M). If T earns a 12.5 percent return on its capital investment, resulting in QBI of $1.25M (12.5 percent x $10M), T could deduct 20 percent of the entire return (20 percent x $1.25M = $250,000) without exceeding the cap, thereby taxed at a maximum effective rate of 29.6 percent on the $1.25M.

Example 2 illustrates the wage/qualified property limitations. T files a separate return on which T reports taxable income of $1,000,000 (determined without regard to the pass-through deduction). T is a partner in a qualified trade or business that is not a specified service business (qualified business A). T also received $20,000 in qualified REIT dividends. T's allocable share of QBI from qualified business A is $600,000, 20 percent of the QBI with respect to business A is $120,000. T's allocable share of wages paid by qualified business A is $200,000 and 50 percent of W-2 wages is $100,000. 25 percent of the W-2 wages is $50,000. The unadjusted basis immediately after acquisition of all qualified property is $5,000,000. 2.5 percent of all qualified property is $125,000. As T's taxable income is above the threshold amount ($157,500) for a single individual, the wage limit for qualified business A is applicable. T's deductible amount for qualified business A is $100,000 (the $120,000 is limited to the 50 percent of W-2 wages of $100,000) and 20 percent of the $20,000 qualified REIT dividends ($4,000) for a total of $104,000.

Example 3 illustrates a taxpayer not subject to the wage / qualified property limitations. H and W file a joint return on which they report taxable income of $200,000 (determined without regard to the pass-through deduction). H has a sole proprietorship qualified trade or business that is not a specified service business (qualified business A). W is a partner in a qualified trade or business that is not a specified service business (qualified business B). H and W have a carryover qualified business loss of $50,000.

H's QBI from qualified business A is $150,000. 20 percent of the QBI with respect to the business is $30,000. Since H and W's taxable income is below the threshold amount for a joint return ($315,000), the wage limit does not apply to qualified business A. H's deductible amount for qualified business A is $30,000. W's allocable share of qualified business loss is ($40,000). 20 percent of the qualified business loss is ($8,000). As H and W's taxable income is below the $315,000 threshold amount for a joint return, the wage limit does not apply to qualified business B. W's deductible amount for qualified business B is a reduction to the deduction of ($8,000).

H and W's combined deduction of $12,000 is comprised of the deductible amount for qualified business A of $30,000, the reduction to the deduction for qualified business B of $8,000, and the reduction of $10,000 attributable to the carryover qualified business loss. H and W's deduction is limited to 20 percent of their $200,000 taxable income or $40,000. H and W's deduction for the taxable year is $12,000.

The following examples illustrate situations involving real estate assets.

Example 4. A pass-through business purchases an office building for $20M ($14M attributable to the structure, $6M attributable to the land) that generates annual rental income of $1.2M (approximate 6 percent return on assets). The maximum allowable pass-through deduction would be $240,000 (20 percent of $1.2M). Note that even if the business paid no wages, the business would qualify for the full deduction because 2.5 percent of $14M (the unadjusted basis of the building) is $350,000.

By limiting the amount of the deduction to a pass-through entity's payment of W-2 wages and its acquisition of depreciable business assets, the Tax Act creates incentives for pass-through entities to hire employees and/or to purchase new business property.

Example 5. Assume a passive investor, T, with $1M of other income invested $10M in a parking lot leased to an operator. T has no wages paid and no depreciable property. The leased business generates $1M of net rental income. T receives no Tax Act benefits because no wages are paid and T does not have an investment in depreciable assets.

Example 6. If instead of a leased parking lot, T's investment is in a depreciable high-rise parking garage leased to an operator, a 20 percent deduction of $200,000 would be allowed (20 percent of $1M). The annual limitation is 2.5 percent of $10M, or $250,000. The $250,000 limitation continues regardless of any actual depreciation of the garage, for the longer of 10 years or the actual useful life of the structure, as long as it is used in the business.

Example 7. If T's investment is in the parking lot (instead of the high-rise garage), that had gross revenue of $1.4M and incurred wages of $400,000 for security guards, the $200,000 deduction would be fully allowable because it would not exceed 50 percent of the taxpayer's wages. However, if T had $1.4M of gross rents and paid $400,000 to a security company to provide security services with its own employees, no Tax Act benefits would be allowable. Wages count, but payments to contractors do not, even if the contractor is providing personal services performed by its employees.

Peter M. Fass is a partner at Proskauer Rose.