Tax reform will change the way rental income is taxed to landlords beginning in 2018. Under current law, rental income is classified as “passive income” and that income simply passes through to the owner’s personal tax return and they pay ordinary income tax on it. Beginning in 2018, rental income will be eligible to receive the same preferential tax treatment as the “qualified business income” (QBI) for small business owners.
Starting in 2018, taxpayers with qualified business income (including rental income), may be eligible to take a tax deduction up to 20% of their QBI. Determining whether or not you will be eligible to capture the full 20% deduction on your rental income will be based on your total taxable income for year. The taxable income thresholds are as follows:
Single filers: $157,500
Married filing joint: $315,000
“Total taxable income” is not your AGI (adjusted gross income) and it’s not just income from your real estate business or self-employment activities. It’s your total taxable income less some deductions. The IRS has yet to provide us with full guidance on the definition of “total taxable income”. For example, let’s assume you have three rental properties owned by an LLC and you net $50,000 in income from the LLC each year. But your wife is a lawyer that makes $350,000 per year. Your total taxable income for the year would be $400,000 landing you above the $315,000 threshold.
Below The Income Threshold
If your total taxable income is below the income thresholds listed above, the calculation is very easy. Take your total QBI and multiply it by 20% and that’s your tax deduction.
Above The Income Threshold
If your total taxable income is above the thresholds, the calculation gets more complex. If you exceed the income thresholds, your deduction is the LESSER of:
- 20% of QBI
- The GREATER OF:
- 50% of W-2 wages paid to employees
- 25% of W-2 wages paid to employees PLUS 2.5% of the unadjusted asset basis
The best way to explain the calculation is by using an example. Assume the following:
- I bought a commercial building 3 years ago for $1,000,000
- I have already captured $100,000 in depreciation on the building
- After expenses, I net $150,000 in income each year
- The LLC that owns the property has no employees
- I’m married
- I own a separate small business that makes $400,000 in income
Since I’m over the $315,000 total taxable income threshold for a married couple filing joint, I will calculate my deduction as follows:
The LESSER of:
- 20% of QBI = $30,000 ($150,000 x 20%)
- The GREATER of:
- 50% of W-2 wage paid to employees = $0 (no employees)
- 25% of W-2 wages page to employees plus 2.5% of unadjusted basis
(25% of wages = $0) + (2.5% of unadjusted basis = $25,000) = $25K
In this example, my deduction would be limited to $25,000. Here are a few special notes about the calculation listed above. In the 11th hour, Congress added the “2.5% of unadjusted basis” to the calculation. Without it, it would have left most landlords with a $0 deduction. Why? Real estate owners typically do not have W-2 employees, so 50% of W-2 wages would equal $0. Some larger real estate investors have “property management companies” but they are usually setup as a separate entity. In which case, the W-2 income of the property management company would not be included in the calculation for the QBI deduction.
Another special note, the 2.5% is based on unadjusted basis and it’s not reduced by depreciation. However, the tangible property has to be subject to depreciation on the last day of the year to be eligible for the deduction. Meaning, even though the 2.5% is not reduced for the amount of depreciation already taken on the property, the property must still be in the “depreciation period” on the last day of the year to be eligible for the QBI deduction.
Tony Nitti, a writer for Forbes, also makes the following key points:
- The depreciable period starts on the date the property is places in service and ends on the LATER of:
– 10 years, or
– The last day of the last full year in the asset’s “regular” (not ADS) depreciation period
Meaning, if you purchase a non-residential rental building that is depreciated over 39 years, the owner can continue to capture the depreciation on the building but that will not impact the 2.5% unadjusted basis number for the full 39 years of the depreciation period.
- Any asset that was fully depreciated prior to 2018, unless it was placed in service after 2008, will not count toward the basis.
- Shareholders or partners may only take into consideration for purposes of applying the limitation 2.5% his or her allocable share of the basis of the property. So if the total basis of commercial property is $1,000,000 and you are a 20% owner, you basis limitation is $1,000,000 x 20% x 2.5% = $5,000
Phase-In Of The Threshold
The questions I usually get next is: “If I’m married and our total taxable income is $320,000 which is only $5,000 over the threshold, do I automatically have to use the more complex calculation?” The special calculation “phases in” over the following total taxable income thresholds:
Single filers: $157,500 – $207,500
Married filing joint: $315,000 – $415,000
I won’t get into the special phase-in calculation because it’s more complex than the special “above the income threshold” calculation that we already walked through but just know that it will be a blend of the straight 20% deduction and the W-2 & 2.5% adjusted basis calculation.