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Will you pay tax on 80% of your flow-through income? Maybe, Maybe Not

Anchin’s Real Estate UpdateApril 2, 2018Marc Wieder, CPA - Real Estate Co-Leader
Will you pay tax on 80% of your flow-through income? Maybe, Maybe Not

Many people who earn income from pass-through businesses think that under the 2018 Tax Act, they will only be paying tax on 80% of their flow-through income, since the Act provides for a deduction of 20% from this income. In fact, the least amount of the income you will pay tax on is 80% but you may in fact pay tax on 100%.

For tax years beginning in 2018, the Tax Act establishes a deduction of up to 20% of qualified business income (QBI). QBI is generally defined as the net amount of qualified items of income, gain, deduction and loss from any qualified business of the non-corporate owner. QBI does not include investment income, guaranteed payments and reasonable compensation income from the business. QBI includes all income from real estate businesses including management, rental income, leasing income, and gains from sale of real estate.

A single taxpayer with taxable income of $157,500 or less and a married couple filing jointly with taxable income of $315,000 or less will be entitled to the full 20% deduction. All others must follow the following steps:

  1. The taxpayer aggregates all their QBI from a trade or business, not entity, therefore all real estate entities get combined, and multiplies this amount by 20%.
  2. The taxpayer then multiplies their allocable share of W-2 wages deducted in arriving at net income from this trade or business and multiplies it by 50%
  3. Third, the taxpayer multiplies their allocable wages from this trade or business by 25% and adds to this result 2.5% of their allocable share of the unadjusted basis of depreciable assets from these entities.
  4. The results from 2 and 3 are compared and the taxpayer takes the greater of the 2 results.
  5. The taxpayer then compares the result in step 4 to the result in step 1 and the lower of these results is the amount deductible by the taxpayer against their flow-through income, subject to the following limitation

The final limitation is as follows: If the 20% of the taxpayer’s taxable income after subtracting capital gains is less than the result in step 5 above, then the deduction is limited to this result.

As you can see, it is possible to not be allowed any deduction from your flow-through income. Therefore, 20% is the maximum you will be entitled to, but not guaranteed.

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