Earlier this year, I noted in this blog that the home mortgage interest deduction “marriage penalty” ambiguity that had previously existed under the Internal Revenue Code (“IRC”) was apparently left unresolved in Congress’s haste to enact tax reform. Now that a few months have passed since passage of the sweeping federal tax overhaul known as the Tax Cuts and Jobs Act, the shock is starting to fade, and we are beginning to get a better feel for some of the impacts of the new law. Still, for those of us whose professional activities are heavily intertwined with tax matters, we continue to contend with some of the more uncertain aspects of these changes.
In particular, the new tax law has introduced a number of additional terms that will have a sizable effect on real estate investors and their holdings. Of keen interest to many is the “Deduction for Qualified Business Income of Pass-Thru [sic] Entities,” codified at new Section 199A of the IRC. This new provision, ostensibly crafted to benefit “pass-through entities” (business organizations that are not taxed separately but pass their profits on to the owner for tax purposes), could provide real estate investors with a federal income tax deduction of up to 20 percent of their net rental income for tax years 2018 through 2025. In addition, taxpayers who hold interests in a real estate investment trust (“REIT”) may also be able to deduct up to 20 percent of their ordinary REIT dividends.
Due to the complexity of the statute’s language, however, it is uncertain whether an investor will need to actually create a pass-through entity in order to qualify to take the deduction with respect to their investment property. “It’s not 100 percent clear,” said Jeff Levine, director of financial planning with Blueprint Wealth Alliance. While the new law provides that the deduction may only be taken in connection with “a qualified trade or business,” it does not, however, define a “qualified trade or business,” and that terminology has different meanings under different parts of the IRC. “Depending on IRS interpretation, a taxpayer’s involvement in the rental property could be a factor” in qualifying for the deduction, according to Levine. As such, taxpayers who report their real estate investment income on Schedule E may be able to claim this deduction; alternatively, they may need to form an actual pass-through entity (e.g., an S corporation, a partnership, or an LLC) to qualify.
A few years back, I wrote a special report recommending the use of limited liability companies to hold title to real estate in order to manage risks. In that report, I pointed out the specific benefits of LLCs for reducing liability, along with a discussion of other factors affecting the decision to hold title to real estate in that manner. For those of you who may have structured your real estate investments in this manner to take advantage of those protections, you should be ideally positioned to claim this deduction.
Still, caution should be exercised in determining whether to proceed with the use of a pass-through entity for your real estate investments for tax purposes. Recently, John M. Wunderling, a partner at my firm specializing in tax, trusts and estates, and corporate law, gave a series of presentations about the intricacies of the new tax law, which pointed out a number of the complexities involved with the 20 percent deduction for pass-through entities, including limitations, exclusions, and phase-out points, in addition to the uncertainties caused by the lack of regulatory guidance. Before setting your sights on using that 20 percent deduction for your real estate investments and creating a pass-through entity to hold those investments, you would be well advised to consult with a skilled tax professional to make sure that the benefits of the new law will be available to you, and that the benefits are not outweighed by the costs.