2018 Tax Update: Tax Changes for the Real Estate Professional
- Elimination of business entertainment deduction (1:20)
- Addition of 20% business income deduction (5:14)
Transcript and Slideshow
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EML: (lower third - Evan M. Liddiard, CPA (first line) Director of Federal Tax Policy, National Association of REALTORS® (second line)
My name is Evan Liddiard of the National Association of REALTORS®. Welcome back to our video series on what you need to know about the new tax law. In this segment, we will explore a couple of business tax changes for those who are self-employed. These apply to a high percentage of those who make their living helping people buy and sell real estate.
Joining me again is Peter Baker of the Business Planning Group. Peter has decades of experience helping REALTORS® and real estate businesses with their taxes.
PB: (lower third - Peter G. Baker, CPA (first line) Founder of Business Planning Group, Washington, DC (second line)
Great to be back, Evan.
Today we have just two provisions to go over, and they contrast with each other. The first is a new and pretty significant tax deduction for most of you, while the second is a small and annoying repeal of an old partial tax deduction. So, one is big and welcome news. The other is bad news but is much smaller in importance.
You may have heard a little bit about both of these changes, but perhaps you do not know how or if they apply to your own situation.
Peter, it's like the old saying, we have some good news and some not so good news - which do you want first?
Let's start with the bad news, Evan, then we can end this video on a very positive note.
Good thinking, Peter. Our first provision is a cutback in the deduction for business entertainment expenses. This is something on which many REALTORS® spend at least some money every year.
[Slide 1 - Deduction for Meals and Entertainment]
Up through the end of 2017, if a self-employed real estate professional took a business contact out to a ballgame or other entertainment event that either preceded or followed a business discussion, then 50% of the cost of the entertainment was deductible as a business expense. A similar rule also applied for a meal where business was discussed - 50% of the cost was deductible.
However, the new tax act changed this by repealing the 50% deduction for all entertainment expenses, even if they are related to a business discussion. This was effective as of January 1, 2018. Fortunately, the 50% deduction for business meals was retained.
Peter, this sounds pretty straightforward. How big of a change is this and is there anything else our viewers need to know?
As you said, Evan, for most taxpayers, this is more of an annoyance than a big dollar item. Yes, many REALTORS® will have slightly lower deductions, and that is never good, but maybe just as irritating is the fact that this is just one more change, one more bookkeeping entry, to have to deal with.
Until recently, there were some unanswered questions about how this change was really going to affect business people.
For example, suppose an agent named Randi Realtor were to take her business contacts Bob and Bev to a baseball game. She not only paid for the tickets but also buys hot dogs, soft drinks, and ice cream for all three while watching the game. How is this going to be treated - as a meal, which is still partially deductible, or as entertainment, which is now non-deductible?
In early October, the IRS released temporary guidance, which tax filers can rely on until the final rules come out, likely later this year.
The guidance makes clear that in cases where both food and entertainment is present, the cost of the food is still 50% deductible if it is purchased separately, or if the cost of the food is set out as a separate line item. So, in the case of Randi, the cost of the tickets is not deductible. However, since she paid for the food separately, she can deduct 50% of the food cost.
What if Randi took her guests to one of those nice stadium suites, where food is available? Doesn't part of Randi's cost represent the food?
Yes, but unless the cost of the food is set out as a separate line item, then all the cost will be allocated to entertainment and none of it will be deductible.
One situation I hear about from NAR members is when a Realtor hosts a reception for clients and potential clients and offers food. This is not exactly a business meal and it isn't really entertainment either. Peter, how do you think the temporary guidance applies to this situation?
Although the new guidance does not specifically say so, I would advise my clients to plan to take a 50% deduction for any food they purchase for business meetings or receptions like this, or for open houses where they host potential clients.
Well, that was not so painful, was it? And now we can move on to the good news, which is much bigger.
What is this new deduction I mentioned? It goes by several different names but probably the easiest is the "Deduction for Qualified Business Income." But you also might have heard it called the "Pass-Through Business Deduction" or the "199A Deduction," which refers to the section where it is found in the Internal Revenue Code.
[Slide 2 - Deduction for Qualified Business Income]
This is a deduction of up to 20% of certain business income of sole proprietors of businesses, such as independent contractors, and for owners of so-called pass-through businesses.
I think understanding the deduction might be a little easier if we first talk a bit about why it was included in the new tax law.
[Slide 3 - Centerpiece of New Tax Law]
As tax reform bill was being developed in Congress last year, there were many ideas that were discussed as being key parts. But the most essential element and centerpiece was a huge reduction in the corporate tax rate - a drop from 35% all the way down to 21%.
Making such a big change has lots of implications, both in and out of the corporate world. Not all business activity takes place within regular corporations. Indeed, more than 90% of all of America's business entities are not regular corporations. Instead, they are organized as partnerships, limited liability companies (LLCs), S corporations, or most common of all, just plain old sole proprietorships.
These businesses have one thing in common, and that is they report their income on their owners' individual tax returns. In fact, these businesses do not directly pay taxes at all. Instead, the tax liability is passed through to the owners.
There were two big concerns about drastically cutting the tax rate only for regular corporations. The first was political - what kind of signal to Main Street America would be sent if the new law only cut taxes for the big boys, but not for the millions of smaller businesses? This is not a good way to win friends if you are interested in reelection.
The second problem was more practical. What was to stop all these millions of small businesses from changing their status by incorporating to take advantage of these lower tax rates?
Thus, the architects of the tax bill knew that if they were going to include a big tax rate cut for corporations, they had to also put in a similar tax cut for these pass-through businesses too.
But this was a real problem, because unless there are certain safeguards in place, what is there to stop regular wage and salary earners from simply becoming independent contractors rather than employees and cutting themselves in on the action?
In the end, the provision that survived was a big surprise for most of us - a 20% deduction from net business income. This was much higher than was featured in earlier versions. And another surprise was that the deduction was available to all kinds of services businesses with incomes below certain thresholds.
[Slide 4 - Basics of Deduction for Qualified Business Income]
So, let's get into some details. This can be confusing because it is a brand-new concept.
It is important to note that the new deduction is not an itemized deduction. Nor is it a typical business deduction that is based on an expenditure. Rather, it is an across-the-board deduction from net income that is computed after other expenses have been factored in.
[Slide 5 - List of Specified Service Businesses]
The next thing to know is that the general rule of the new provision limits the deduction to non-specified service businesses. Well, what are these? This is tax law parlance for businesses in the following fields:
"any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing or investment managing, trading, dealing in certain assets, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees."
[Switch back to Slide 4]
You may be thinking that most real estate professionals are going to be classified in the definition of a specified service business. And this is what was expected.
But there is lots of good news here. And it has gotten even better with the recent release of guidance from Treasury and IRS. Peter, what is the first bit of good news?
A major exception was added right before the bill was enacted that allows almost any pass-through business owner with less than a certain amount of taxable income to still take the deduction, despite their being in one of these specified service businesses (SSB).
The exception provides that if the business owner has taxable income of less than $157,500 as a single taxpayer, or $315,000 as a married couple filing a joint return, then the restriction does not apply.
In other words, everyone who has qualified business income will be able to take the deduction, so long as their taxable income is below these thresholds.
And for those with income above these amounts, there is still hope. There are phase-in ranges of $50,000 for singles and $100,000 for joint returns. Over these ranges, the deduction is ratably phased out. If this sounds confusing, you are in good company. But we are going to cover some examples in a few moments that should help clarify.
[Slide 5 - Specified Service Businesses]
Now, for the second bit of good news. Take another look at this list of service business fields, which are prohibited from claiming the 20% deduction if their income is over the thresholds.
When preliminary guidance came out in, it specifically said that real estate is not included in the term "brokerage services." Instead, this term was limited to the brokerage of stocks and other securities.
This big win for the real estate was at least partly the result of a huge effort by NAR in urging Treasury and IRS to remove real estate from the list.
To sum up, the first exception allows all real estate professionals with income below the thresholds to claim the 20% deduction. And the recent guidance says that even real estate agents and brokers with incomeabove the thresholds will be eligible for a deduction of up to 20%, according to a formula.
[Slide 6 - 2nd Set of Exceptions for Non-Specified Service Business Income]
This formula provides that the 20% deduction is available, but is limited to the greater of:
1) 50% of the W-2 wages paid by the business, or
2) the total of 25% of the W-2 wages paid by the business plus 2.5% of the original cost basis of the tangible depreciable property of the business at the end of the year.
Confusing, right? Hopefully you can see that in order to get a deduction if you are over the taxable income thresholds, to qualify for any deduction your business will need to either pay (W-2) wages to employees, or own depreciable property, or both.
It might be best if we try to explain this using some examples.
[Slide 7 - Amy Agent]
In this first example, we are looking at a fairly average Realtor named Amy Agent. She has net commissions of $67,000 for the year, after deducting all of her normal business expenses.
The first thing to notice is that unlike under the prior law, Amy is eligible for a 20% deduction of $11,000. This makes a big difference. We discussed the changes in the personal exemption and the standard deduction in earlier segments and you can see their impact here as well.
The bottom line for Amy is that she gets a tax cut compared with the prior law of over $4,200. And more than half of it, $2,420, is attributable to the new 20% deduction.
But, if Amy had earned commission income greater than the threshold amount of $157,500, a partial deduction may be available.
[Slide 8 - David Developer]
Our last example shows what happens when someone has income far above the threshold. David Developer owns an S corporation and he pays himself $80,000 in salary from the business. But the company also earns $370,000 in net income, which is passed through to David on his own tax return.
As you can see, David and his spouse are right at the phase-out level of $415,000. But because his income does not come from one of the specified businesses where higher income is not eligible for the deduction, we can look to the formula to see how much deduction he gets.
David's salary of $80,000 is one factor, which provides the deduction can be no higher than 50% of the salary paid by the company. This would be $40,000. But the second limiting factor would give him a higher deduction. This one says that the total of 25% of the salary paid, which would be $20,000, plus 2.5% of the original cost of depreciable property owned by the business.
In this example, we assume that David has a building that is worth $1.8 million, not counting the land. 2.5% of this amount is $45,000. Add this to the $20,000 and we get a deduction of $65,000. This is a big number but it is still smaller than the full 20% of his net business income, which is $74,000.
The bottom line tax saving for David compared with the prior law is over $38,000, of which more than $21,000 comes from the new deduction and the rest is from lower tax rates and other changes.
These new changes really are revolutionary for owners of pass-through businesses and the self-employed. My clients are very excited about these changes but they are also quite confused. It is complicated.
This is why we recommend that you consult with a qualified tax advisor on this new deduction. Every situation is different and we still do not have the final guidance on how this is going to work in very situation.
This concludes this segment of our video series. We hope you have found these to be informative and valuable. Please feel free to email me with general questions. NAR is not allowed to give specific tax advice but we may follow up with clarification in a subsequent video. Thanks for watching.