Pass-through tax deduction rules you need to know
To take advantage of the pass-through deduction, you need to have pass-through income. In a nutshell, this refers to business profits -- that is, the amount you make when adding up all your revenue and subtracting your deductible business expenses.
Importantly, pass-through income does not include the following:
- Short- or long-term capital gains, even if they're generated by a pass-through business. For example, if you sell your business for more than you paid to acquire or start it, that's a capital gain, not business income.
- Dividends or interest income. REIT dividends are an exception, since REITs are pass-through entities.
- Wage income you're paid, even if it's from a qualified business type like an S-corporation. If your income was reported on a W-2, it's probably not qualified business income for the purposes of this deduction.
The pass-through deduction is based on your overall net business income or loss, which is an important concept to understand if you have a few qualifying income sources.
For example, if you have $20,000 in qualified income from a convenience store you own, $5,000 from a rental property, and a $30,000 loss from another business, you would have a net loss of $5,000 per year and couldn't use the pass-through deduction. In other words, you can't choose to take the deduction only for your profitable businesses.
Furthermore, if you have a qualified business income loss for a given year, you must carry the loss over to the next tax year. Continuing our previous example of a $5,000 loss, let's say you have a net QBI profit of $30,000 the next year. You'd need to apply the $5,000 loss, reducing your deductible qualified business income to $25,000.
You also need to have taxable income. This sounds rather obvious -- after all, to deduct something from your taxable income, you need to have taxable income in the first place. However, if you have qualified business income but your other deductions (e.g., the standard deduction) leave you without any taxable income, you can't use the 20% pass-through deduction.
A simple example of the 20% pass-through tax deduction
Before we go any further, let's look at a simple example. We'll say you earn a salary of $70,000 in 2019 from your job and $30,000 from consulting work you do on the side, which is paid to you through an LLC. After accounting for your other deductions, you're in the 22% tax bracket.
The pass-through deduction allows you to deduct $6,000, or 20% of your consulting income. Because you're in the 22% tax bracket, you save $1,320 on your taxes for the year.
Who doesn’t qualify for business deductions?
It's important to note that not everyone who has pass-through income can take advantage of this deduction. There are income limitations for taxpayers whose income is from certain "specified service" businesses. For example, doctors and lawyers who operate their own practices are included in the specified service definition and are subject to income limitations when it comes to the pass-through deduction.
It's easy to see why this limitation exists. The pass-through deduction was intended to reward Americans who start and operate businesses, not to give tax relief to highly paid professionals who happen to be self-employed.
Here are just some of these service businesses:
- Health professionals
- Performing artists
- Consulting services
- Financial services
- Brokerage services
- Investment management businesses
- Any business with a principal asset of the reputation or skill of its owner(s) or employee(s). This includes businesses where income results from endorsements of products or services; licensing of the owner's image, likeness, or other characteristics; or if the primary income source is from the owner making media or event appearances.
For taxpayers in 2019 whose pass-through income comes from one of the specified service businesses, the deduction begins to phase out above taxable income of $321,400 for those married filing jointly or $160,700 for all others. The keyword in that last sentence is "phase out." Taxpayers whose income exceeds these thresholds can potentially get some deduction. And these thresholds will be adjusted for inflation in 2020 and subsequent years.
Unfortunately, calculating the deduction becomes considerably more complex above these thresholds.
If you're not in one of the listed service businesses but your income exceeds the phase-out threshold
If you exceed the phase-out threshold by $100,000 or more ($50,000 for individuals), a special rule applies, known as the W-2 wage/business property limitation. For 2019, this happens if your taxable income is greater than $421,400 (joint return) or $210,700 (everyone else).
In this case, your deduction would be limited to the greater of
- 50% of your share of W-2 employee wages paid by the business or
- 25% of your share of W-2 wages plus 2.5% of the acquisition cost of your business property.
Of course, the deduction is still limited to a maximum of 20% of your qualifying pass-through income.
Let's say you own a property management business that's structured as an LLC with you as the sole owner. Property management isn't on the exclusion list above. Your business income is $300,000 and, combined with a spouse, your total taxable income is $450,000. You own business assets worth $250,000 and paid three employees a total of $100,000 in W-2 wages during the year in question.
So, 20% of your qualified business income would be $60,000. By the 50%-of-wages method, your deduction would be limited to $50,000. By the other method, 25% of W-2 wages plus 2.5% of business property, your deduction would be limited to $31,250. Because you can use the higher of the two, you'd be allowed to deduct $50,000 of your business income.
Note that if you don't have any W-2 employees or business property, you can't use the deduction at all if you're in excess of the threshold. However, most real estate businesses own depreciable property, so even if you have very high income, you'll likely be able to take a pass-through deduction for your real estate business income.
If your taxable income is between $321,400 and $421,400 for a joint return or $160,700 and $210,700 for an individual tax return, the W-2 wages/business property rule only applies to some of your qualified business income deduction -- the rest can be deducted at the full 20% rate. In other words, your deduction will be somewhere between the limited deduction method and the full 20%.
If you are in one of the listed service business and your income exceeds the threshold
If your taxable income is greater than the applicable threshold and you operate in one of the specified service businesses, your deduction begins to phase out. Above taxable income of $421,400 (joint return) or $210,700 (all others), you can't use the qualified business deduction at all.
If you're between the lower and upper thresholds that apply to you (so, between $321,400 and $421,400 in taxable income for those married filing jointly and between $160,700 and $210,700 for everyone else), there's a two-step process for calculating the deduction.
First, use the two-part W-2 and business property formula I discussed in the last section to calculate your deduction before the phase-out. Then, reduce your deduction by 1% for every $1,000 you exceed the phase-out threshold by (2% if you don't file a joint return).
If that sounds complicated, it's because it is. Here's as simple of an example as I can give you.
Let's say you're a physician and own your practice. You have qualified business income (QBI) of $300,000 and, combined with your spouse, you have taxable income of $341,000 -- exactly $20,000 over the phase-out threshold. You own business assets worth $500,000 and have W-2 employees who earn a total of $100,000.
First, use the greater of the two-part method to calculate your deduction before the phase-out.
- 50% of the W-2 earnings is $50,000.
- 25% of the W-2 earnings plus 2.5% of your business assets is $37,500.
Now, 20% of your qualified business income would be $60,000, but this method would limit your deduction to $50,000.
However, remember that you're $20,000 over the phase-out threshold and your deduction is reduced by 1% for every $1,000. So, reducing the $50,000 deduction you calculated by 20% gives you a pass-through deduction of $40,000.
The bottom line on the pass-through tax deduction
The pass-through tax deduction can result in serious tax savings for small business owners and real estate investors, especially if you can deduct the full 20% of your qualified income. This can make real estate -- which is already a very tax-advantaged investment -- even more attractive.
As a final thought, you may have noticed that the pass-through deduction is very complex and has many gray areas. After all, the IRS guidance on the deduction is 248 pages long and isn't exactly easy to follow. In 2,500 words, I've only scratched the surface of some of the what-ifs.
If you aren't sure about the eligibility of any of your pass-through income, consult a tax professional to make sure you get it right.