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Opinion: Are real estate developers the winners in tax reforms?

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As real estate activity pushes through 2018 at pre-recession levels, tax planning is top of mind for many real estate developers. Add to that the most sweeping tax reform in decades, and it’s a good time to visit your CPA to discuss how the new tax law might affect you.

One of the highly publicized provisions of the federal Tax Cuts and Jobs Act is the new qualified business income deduction. In an effort to preserve the competitive rate advantage of pass-through taxation, the law generally allows for a deduction of 20 percent of QBI through December 31, 2025, to business owners taxed as sole proprietors, partnerships or S corporations.

So if you’re a real estate developer receiving all your income from pass-through entities, does this mean you can expect a 20 percent haircut on your 2018 taxes?

Not so fast – there are some exceptions that could limit this deduction.

Even though the TCJA was hailed by some as a tax simplification, this portion of the new law has quite a few moving parts to consider.

Let’s start with the first component: QBI. It’s defined as the net amount of qualified items of income, gain, deduction and loss with respect to any qualified trade or business of the taxpayer. In general, this will be domestic business taxable income that doesn’t include any investment items such as capital gains, dividends or interest.

The second part of the QBI definition requires the income be generated by “any qualified trade or business of the taxpayer.” By law, that means any trade or business other than a specified service trade or business – such as the fields of law, accounting, consulting and health – or the trade or business of performing services as an employee. Also excluded from QBI is any business where the main asset is the reputation or skill of one or more of its employees or owners. There are questions on how broadly this aspect of the definition will be applied, and we’ll need guidance from the IRS to answer questions about the scope of the provision. Architects and engineers are specifically excluded from this definition.

There’s one exception to the service business disallowance rule. If a taxpayer’s taxable income is $157,500 ($315,000 for those married, filing jointly) or less, then specified service business income is eligible for the 20 percent QBI deduction. It will be important for taxpayers near these thresholds to time fee payments, e.g. commissions, to meet this test.

Once you determine your income and business are eligible for the deduction, there are two additional limitations on the QBI deduction to consider. First, the overall deduction is limited to 20 percent of the excess of taxable income over the sum of any net capital gain. Second, for those with taxable income of $207,500 ($415,000 for married, joint filers) or more, the deduction is the lesser of 1) 20 percent of the taxpayer’s QBI or 2) the greater of 50 percent of the W-2 wages with respect to the business or 25 percent of the W-2 wages with respect to the business plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property.

Real estate businesses typically don’t pay a lot of wages, and their operating expenses are capital-intensive, so for developers, it may be more advantageous to go with the second test: 25 percent of wages plus 2.5 percent of unadjusted basis of property immediately after acquisition.

For purposes of this article, we’re assuming rental real estate developers are in the trade or business of real estate. There are situations where rental real estate investors won’t meet the trade or business threshold, which wouldn’t allow them a QBI deduction. The question of when a rental activity becomes a trade or business rather than an investment activity is an item that needs clarification from the IRS.

We expect additional guidance in the form of U.S. Department of the Treasury regulations in late summer. For now, stay in contact with your tax adviser to discuss ways to get the most out of your QBI deduction in 2018.

Erica Smith is a director at BKD LLP. She can be reached at esmith@bkd.com.

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