Changes stemming from the Tax Cuts and Jobs Act of 2017 allow agents and brokers who earn income as independent contractors or from pass-through businesses to take a significant deduction on that income.
By Robert Freedman
One of the biggest wins for REALTORS® in last year’s tax reform bill is the new 20 percent business income deduction, also known as Section 199A. Almost any self-employed person or owner of a pass-through business (such as an S corporation, limited liability company, or partnership) with eligible income, which the National Association of REALTORS® made sure includes commissions from real estate sales, can take 20 percent off the top after business expenses are taken out.
Of course, there are limits. If you file as an individual, you’re eligible up until your taxable income reaches $157,500. After that, your deduction phases out over the next $50,000, until you reach $207,000. For couples filing jointly, the taxable income limit is $315,000, with a $100,000 phase-out until you reach $415,000. That applies to your combined income. So, your spouse’s income can impact your eligibility.
Real estate professionals with incomes above those amounts also may be eligible for the deduction but, in this case, it’s based on a formula that looks at wages paid and depreciable business property.
What should you be doing to ensure you’re positioned to get the most out of the deduction in your 2018 taxes, due next year in April? To find out, REALTOR® Magazine talked to Peter Baker, a certified public accountant and principal of Business Planning Group in Washington, D.C. Baker’s practice specializes in real estate agents and brokers and he’s already begun having conversations with his clients about what to do.
Most real estate professionals are sales associates and are sole proprietors. Is there any tactical reason for them to restructure themselves into an LLC or S corporation to get a better deal under the deduction?
No. From the standpoint of 199A, a change in entity type is not necessary because sole proprietorship income qualifies for the deduction. Absent other reasons to change, they should keep filing as a sole proprietorship.
What if you’re a broker or otherwise have pass-through income in addition to commissions earned?
The deduction is taken on an aggregate basis, so if you have pass-through income from other sources in addition to commissions, then you combine your qualified business income with any qualified business losses before you calculate your deduction. So, if you have $100,000 in net commission income and $50,000 in qualified losses from other sources, the 20 percent would come off the aggregate amount, or $50,000. That means your potential deduction would be $10,000.
What pass-through activities would generate losses?
Many things do. It’s not uncommon for brokerages to throw off losses today because of generous splits with sales associates. So, if you’re a broker-owner who still sells, you might have losses from your brokerage operation while generating commissions earned from your own sales.
What if you have investment rental property or you’re involved in land or property development? Those can throw off losses, right?
These are most often operated in pass-throughs, but we’re still waiting on final IRS rules. So, we don’t know yet about how net rental income and losses will be treated. [Editor’s note: NAR is working with the IRS to get clarification on that question.]
The deduction is taken on your net qualified business income. There’s no change to what counts as deductible business expenses, right?
With the exception of some new rules for depreciation and changes in deductibility for meals and entertainment, that is correct. You take out your expenses in much the same way. Did you travel to conventions? Did you buy a new car? Did you buy a computer? Did you buy office supplies?
Sales associates and brokers typically aren’t wage or salary earners, so they don’t get W-2 income and are required to pay estimated taxes quarterly. That means they’ve already paid three quarterly estimates for the 2018 tax year even though rules aren’t out on the new deduction, or on other changes in the tax law, for that matter. What’s going to happen come April if their estimated payments are off?
Hopefully they’ve been talking to their professional tax adviser or accountant for the previous quarters. There are two ways to approach estimated tax payments given the new environment. The taxpayer can apply what’s known as the safe harbor approach. That’s where they pay estimated taxes based on their prior year’s tax liability. As long as they do that, even if they end up owing more tax come April 2019, they won’t be penalized or face interest charges for underpayments. They’ll just have to settle up the amount they owe. Of course, if their current sales volume is down from the previous year, that could be a painful way to do it, because they’ll be basing their payments on higher income than they actually earn. So, the alternative is to forecast taxable income based on what they’ve earned year-to-date, subtract business expenses, and look at their pipeline of likely sales to forecast their anticipated earnings for the remainder of the year. Then, they factor in the 20 percent deduction.
If they don’t take the safe harbor approach, are they liable for penalties and interest payments if they underpay their taxes?
Potentially, they would be. However, the IRS has a first-time penalty abatement process for taxpayers who, for the past three years, have paid and filed their taxes on time and haven’t incurred any penalties. So, if they have a good three-year history, they would be eligible for a one-time waiver of penalties and interest payments if they underpay their taxes.
You mentioned final rules aren’t out yet. When can we expect them?
Hopefully, before the end of the year. The IRS will also be revising forms to reflect the new qualified business income deduction. That should also be coming out before the end of the year.