Qualified Business Income Deduction: Facts and Tips 2022

Facts about the Qualified Business Income Deduction

Rarely is there anything sexy or intriguing about the U.S. tax code? But in recent years, several developments have meant more businesses can save and reinvest large amounts of money, tax-free, back into their businesses. The most remarkable change to the tax code is IRC 199A: the Qualified Business Income Deduction [QBID]. Pass-through or sole-proprietorships in the U.S. that provide a “qualified trade or business” can automatically make the first 20% of their net taxable income tax excluded. Tax-excluded means paying zero taxes on a given part of your earnings. This is a game-changer for many taxpayers in the United States, as much of those savings can be invested into a SEP for retirement or capital investment.

What Is Qualified Business Income (QBI) Deduction?

To define what the Qualified Business Income Deduction is, it is important to consider why the government created it. The government wanted to empower two groups: retirees and real estate investors. These groups are not typically viewed as needing tax assistance, but the Tax Cuts & Jobs Act [TCJA] put a cap on the amount of state and local property tax one could claim on their taxes for a typical itemized deduction. It was meant to incentivize citizens in higher-tax states to demand local and state property taxes be reduced. 

At the same time, it harmed many wealthy people, like real estate professionals. For example, how can you incentivize someone to buy a house in a township in Central New Jersey with an average property tax of $26,000 if the future landowner could only deduct $10,000? Thus, the creation of this miraculous tax deduction! 

But how do we know that this was meant for real estate? There is a special safe harbor rule for real estate professionals within IRS Notice 2019-07. Also, even if the taxpayer does not qualify fully under the QBI guidelines, the rental property or real estate income is still likely to qualify, so long as it is held for more than a year. This prevents home flippers from using this tax deduction to hyper-inflate the housing market. If you are a qualified business, so long as you make less than a certain threshold and meet other criteria, you have the unprecedented opportunity to decrease your tax liability considerably through 2025. 

This may sound too good to be true, and in some ways, it is because there are several hoops to jump through. Yet, the potential wealth that you could potentially generate using such a deduction is rarely seen in the tax code. Therefore, it is worth investigating if you or your spouse may be eligible for the QBI deduction.

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How Does Qualified Business Income Deduction Work?

In short, a qualifying business would deduct the lesser of two calculations from their taxable income that each are focused on eliminating 20% of that qualified income. However, there is another way to reap such benefits. Income and dividends related to a Real Estate Investment Trust [REIT] and some forms of income from a Publicly Traded Partnership [PTP] may qualify for such treatment. Therefore, in many ways, this is akin to having “shares” in a real estate endeavor (being a shareholder) without the issues and hurdles of short and long-term capital gains too frequently.

Who Qualifies for the Qualified Business Income Deduction?

here are three main exclusions to the QBI Deduction. These are: 1.) the tax-payer can not be an employee; 2.) the entity cannot be a C-Corp; and 3.) the entity cannot be a specificized service trade or business (SSTBs). The first two exclusions are relatively straightforward. Employees that receive W-2 wages are not running a business and, therefore, fall out of the definition. Therefore, the second exception does not have a pass-through quality to its earnings and is not eligible. 

The IRS goes out of its way to describe the exceedingly long list of SSTBs. This is strange in its appearance, not because it lists exclusions and exceptions, but instead because it may as well list what service this was intended for all along – real estate management. According to the IRS, “[a]n SSTB is a trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading or dealing in certain assets, or any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners. 

This may sound like an impossible hurdle to overcome if you fall into any of those services. However, if you are married, you can still reap the benefits of QBID by filing jointly with your spouse, so long as they themselves do not disqualify you for the deduction, generally.

Pass-through-entities

Each state offers a set of choices for the incorporation of a business. You do not need to incorporate at all if you do not want the protections of incorporation but still want the Qualified Business Income Deduction benefits. This wiggle room exists because of federalism and state sovereignty. As a result, IRS has to define sole proprietorship very broadly in order to identify the target group of taxpayers across 50 states and several territories. 

To avoid the issues of definitions, Congress generally focused the law on pass-through-entities. Simply put, these are business structures where the individual taxpayer and the activities of the business are essentially one and the same. That means if the company makes money, it is really the individual who invested, worked, and earned that income rather than an employee of a corporation. In that case, the money made by the corporation does not pass through to you but instead acts as a sift, limiting how much you can earn. There are two main pass-through entities:  the sole proprietorship and the partnership.

Sole Proprietorships

The IRS defines sole proprietorship as “…  someone who owns an unincorporated business by themselves. However, if you are the sole member of a domestic limited liability company (LLC), you are not a sole proprietor if you elect to treat the LLC as a corporation.”

Partnerships

Like a sole proprietorship, a partnership is a pass-through entity for profits, loss, and liability. Just as the partners keep a much larger portion of their business ventures, they are also much more at risk for issues that go awry. PTPs do qualify but on a pro-rata basis. That last part is only important if the company provides more than one service; some do qualify for the QBI deduction, and others do not.

What Type of Income Qualifies for the QBI Deduction?

Generally speaking, the first 20% of net income generated from many trades and businesses is tax excluded if they qualify. The challenge is not falling into the SSTB zone. For the most part, this financial powerhouse was created for real estate management services. This can include income from a REIT or even shares of a publicly traded partnership that qualifies. Granted one is active income and the other is passive income, the IRS groups them together, for the most part, when figuring out your allocable deduction.

How To Get a Qualified Business Income Deduction: Best Tips

  1. The primary method for achieving the QBI deduction is achieving Real Estate Professional Status [RPS]. You do NOT need to become a licensed realtor to achieve this status. Instead, you must check off the boxes on a checklist of business services—it is that easy!
  2. Ensure that you are actively engaged in the real estate management business and keep a calendar to prove your hours. The primary taxpayer that uses RPS to obtain the QBI deduction must be actively engaged in qualifying service. That engagement is mostly based on a percentage of work (at least 50% of it) and a minimum number of hours worked (150+). 
  3. Utilize the BRRRR method: Buy, renovate, rent, refinance, repeat. This utilizes the power of RPS status merged with the 1031 exchange. It also allows clever people to use the 121 deductions combined with a 1031 exchange for even lower taxes. If you use segregated depreciation, you can depreciate the value of the structure and the renovations within typically five versus 27.5 years. 
  4. Follow every rule of the 1031 exchange and consider hiring a professional specializing purely in 1031 exchanges. This will typically be an accounting professional or realtor that can navigate you through the very narrow window of the 1031 exchange. Although the rule says you have to have lived in a home for two of the last five years, you still must notify the IRS that you plan on using the 1031 exchange within just weeks of sale and in anticipation of the sale. 
  5. Contact individuals, business owners, lawyers, and other people intimately connected with real estate transactions to understand the process and make connections. Inflation has made the cost of most businesses increase drastically because of the price of materials.  As a real estate manager, you can help provide income and earnings for your retirement by providing a service that can help decrease the overall cost to shareholders of a real estate endeavor. Interestingly, many of those investment properties are part of our annuities, dividends, and other retirement savings and investments. Therefore, you are in many ways helping your retirement grow.

How to Calculate Qualified Business Income Deduction

Calculating your Qualified Business Income Deduction is easy. According to the IRS, “the deduction is the lesser of:

  • 20% of the taxpayer’s QBI (QBI Component), plus 20% of the taxpayer’s qualified REIT dividends and qualified PTP income (REIT/PTP Component) or 
  • 20% of the taxpayer’s taxable income after subtracting any net capital gain.”

This is a relatively straightforward Internal Revenue Service formula. Most people will fall into the second category if they fail to use a 1031 exchange, which avoids capital gains taxation issues.

The Bottom Line

If you are not yet at the age of SSA retirement and, therefore, still must work, even though your spouse is still working, RPS status is an excellent way for the not-yet-retired spouse to earn income that could reduce their total joint income burden. Why is this an ideal fit for retirees? It appears that the regiment required to keep logs and evidence of your RPS status is well-suited to active seniors with a history of having to organize using many calendars. If it is not clear yet, RPS status is perfect for stay-at-home parents of any age. 

Consider how easy it would be to start offering to manage your friends’ and colleagues’ properties for them at the market rate? Your close connection with them and you are networking all these years in your community will pay off handsomely in this endeavor. So, are you ready to pay less in taxes? If you feel like you are, speak with a conversant business expert in this area, such as an attorney, financial advisor, or another professional consultant.

Article by Brad Biren

Brad Biren is a proud autistic professional, writer, and advocate for neurodiverse people within the business community. He is a tax & elder law attorney with a passion for estate planning and crisis Medicaid planning. His favorite part of his job is Special Needs Planning — a financial and legal roadmap to help families of diversely-abled people cultivate greater opportunities for their loved ones. Mr. Biren also assists startups and nonprofits with optimization challenges through his innovative and novel use of synergies between tax, law, finance, science, and technology.

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