How will the new qualified business deduction affect real estate business owners? In the new Tax Act that was signed into law, sole proprietors, S Corp shareholders and partners in a partnership will be entitled to a deduction equal to 20% of their allocable share of qualified business income, subject to the following limitations:
Generally the deduction cannot exceed 50% of taxpayer's share of the W-2 wages paid by the business. For example, if you receive W-2 wages of $200,000 a year from your S Corp, your 20% business income deduction is limited to $100,000 (50% x $200,000);
Alternatively, the limitation can be computed as 25% of taxpayer's share of the W-2 wages, plus 2.5% of the unadjusted basis (the original purchase price) of property used in the production of income.
In general, rental real estate businesses do not have W-2 employees, thus the first limitation rule above may mean that owners of rental real estate may not be able to take a deduction for their allocable share of business income. However, the alternative limitation rule above may allow them to take the deduction. For example, assume that Joe holds a commercial building purchased a few years ago in an LLC that he co-owns. His unadjusted basis (the original purchase price) of the building was $5 million, and his share of the annual net rental income is $1 million. The LLC pays no W-2 wages. Under the new law, Joe may take a deduction equal to the lesser of:
20% of qualified income ($1milliion x 20% = $200,000), or
25% of W-2 wages ($0 x 25%) plus 2.5% of Joe's share of the unadjusted basis ($5 million x 2.5% = $125,000) (note that he's using the alternative limitation rule here)
Thus, Joe may deduct $125,000. It's important to note that the deduction will be taken as a deduction in arriving at taxable income, rather than reducing adjusted gross income. Richard A. Linder Partner, Real Estate & International Tax RLinder@SingerLewak.com