Calculating the New Pass-Through Deduction for Real Estate Investors

The Pass-Through Deduction, introduced by the Tax Cuts & Jobs Act, allows sole proprietors, partnerships, and S-Corporations to deduct up to 20% of their qualified business income (QBI).

Since many real estate investors operate under one of these entities mentioned, how will this impact you?

Investors with Taxable Income Below $157,500 ($315,000 if married)

If you operate under one of the entities mentioned above, and have taxable income less than $157,500 ($315,000 if married), you will simply be able to deduct 20% of your qualified business income (QBI).

For small landlords that report rentals on Schedule E, this deduction will apply to the aggregate income or loss of your rental activity, and not to each individual property (at least as of this writing). Because rental real estate often creates a loss for tax purposes, this deduction may not apply to everyone.

However, flippers, developers, agents, and larger landlords should see a greater impact from the deduction.

Example: You are a married investor with five rentals that produce net operating income of $90,000. You also have W-2 wages of $160,000, because you are below the $315,000 threshold, you will be able to deduct $18,000 from your net operating income ($90,000 x 20%).

Assuming you are in the 24% tax bracket, you will save $3,600 on your tax bill.

However, if your five rentals produce a net operating loss of $13,700, you are not eligible for this deduction even if one of the five rentals produces net operating income.

Investors with Taxable Income Above $157,500 ($315,000 if married)

If you’re an investor with taxable income above these thresholds ($157,500/$315,000), things get a little more complicated as W-2 wage limitations have to be considered.

Below are the rules to calculate the pass-through deduction if your taxable income is above the phase-out thresholds:

• Combined QBI Amount (in general) is the lesser of:
  • 20% of the qualified business income with respect to the qualified trade or business, or
  • The greater of:
    • 50% of the W-2 wages with respect to the qualified trade or business
    • 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.
  • Qualified property is:
    • Property which is held by, and available for use in, the qualified trade or business at the close of the taxable year,
    • Property which is used at any point during the taxable year in the production of qualified business income, and
    • The depreciable period for which has not ended before the close of the taxable year.

Example: If your QBI is $350,000, your business has $120,000 in W-2 wages, and has qualified business property with an unadjusted basis of $1,200,000, your pass-through deduction will be the lesser of:

• $70,000 ($350,000 x 20%); or
  • 20% of the qualified business income with respect to the qualified trade; or
• The greater of:
  • $60,000 ($120,000 x 50%)
    • 50% of the W-2 wages with respect to the qualified trade or business; or
  • $60,000 (($120,000 x 25%) + ($1,200,000 x 2.5%)
    • 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.

Your deduction in this example would be $60,000. Assuming you’re in the 35% tax bracket, you will save $21,000 on your tax bill. 

The Bottom Line on the Pass Through Deduction

The pass through deduction has the potential to shave thousands off your bill if you operate as a sole proprietor or use a pass-through entity such as a partnership. However, small landlords may not see the benefit if their aggregate rental portfolio shows a loss for tax purposes.

Because this deduction is still new and can be complicated to calculate, it is recommended that you work with your CPA to determine how this deduction will impact your specific situation.

Author: Thomas Castelli, CPA is a Tax Strategist and member of The Real Estate CPA, an accounting firm that helps real estate investors keep more of their hard earned dollars in their pockets, and out of the government’s, by using creative tax strategies and planning.