What Commercial Real Estate Investors Can Expect from Section 199A of the New Tax Code

The IRS finally released its eagerly-awaited updates to Section 199A, and while the latest version of the code faces its final edits, the time of speculation is over. Commercial real estate agents and investors now get a chance to see who is able to take the 20 percent deduction on qualified business income. This information will help commercial agents to guide their clients toward new purchases and allow investors to adjust their strategy accordingly.

Section 199A in a Nutshell

The Trump Administration’s Tax Cuts and Jobs Act brought about a substantial tax reduction for regular corporations, bringing down the highest maximum tax rate from 35 percent to 21 percent. Since these rate reductions only affect C corporations, Congress wanted also to provide some tax relief to entities with pass through taxation — i.e., LLCs, partnerships, S corporations, estates, and trusts.

The Section 199A deduction is (1) the lesser of the following three amounts combined

  • A deduction of up to 20 percent of qualified business income (QBI) from a domestic business structure with pass through taxation.
  • A 20 percent deduction on the dividends from a qualified real estate investment trust (REIT)
  • A 20 percent deduction from qualified publicly traded partnership (PTP) income.

or (2) “an amount equal to 20 percent of the excess (if any) of taxable income of the taxpayer for the taxable year over the net capital gain of the taxpayer for the taxable year.”

In order to qualify for the deduction, taxpayers must meet certain income eligibilities and safe harbor rules. The deduction is for taxpayers whose income falls below a certain threshold, $315,000 for returns filed jointly and $157,000 for single or head of household filers. There may be limited deductions for taxpayers over these thresholds.

The deduction is equal to the lesser of 20 percent of the taxpayer’s QBI plus 20 percent of qualified REIT dividends and PTP income, minus any net capital gains. The amounts will be adjusted for inflation.

One Clear Winner: REITs

REITs emerge as a clear-cut winner in the new tax code, in the sense that Section 199A offers a sure and uncomplicated deduction for this investment, effectively reducing the top taxation rate on REITs from 37 to 29.6 percent. Unlike direct real estate investment, which needs to meet certain safe harbor rules in order to qualify, REITs are not only substantially easier to qualify for the full deduction; they now bring tax benefits that are comparable to long-term capital gains.

Thus, commercial real estate investors should give REITs a fresh look on two levels. First, are they a better long-term investment than directly-held commercial property, which may not qualify for the deduction? Second, where is it more advantageous to hold REITs as an investment? Thanks to the Section 199A deduction, it may better to have them outside a traditional retirement portfolio.

Implications for the Real Estate Rental Market

When Section 199A first passed through the Senate, the deduction was limited to “50% of W-2 wages,” which would have excluded many commercial real estate investors from benefiting. Since then, the committee added an alternate limitation: “25% of W-2 wages plus 2.5% of the unadjusted basis of ‘qualified property.'” This allows real estate investors to substitute property value for W-2 wages, effectively giving real estate investors an “in.”

There are limitations and exclusions, however. In order to qualify for the 20 percent tax deduction, real estate investors who receive rental income from their properties must meet the safe harbor rules set forth in Part III of Section 199A in order to be considered a trade or business under the tax code.

An individual must hold their rental real estate enterprise (the property or properties they hold) directly or in a pass-through business structure in order to claim the deduction. In addition, they must meet the following criteria:

  • Commercial and residential real estate may not be part of the same enterprise, and real estate occupied by the owner as a residence for any part of the year does not qualify.
  • There must be separate accounts for each property.
  • Each property must have at least 250 hours of service performed on it to qualify.
  • Starting January 1, 2019, the taxpayer must keep contemporaneous records, logging all service hours performed on the property. Services may be performed by the owner.

Generally speaking, Section 199A requires careful documentation and favors active commercial real estate investors; in most cases, the deduction is not designed for individuals who earn income from their vacation property.

What impact, if any, will the new tax code how on your real estate investments? Our team here at Peak 1031 Exchange recommends having a frank discussion with your tax and legal advisers to see if you qualify, and to determine the long-term benefits for your investment strategy.