The New Tax Law's Qualified Business Income Deduction

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Includes: CLDT, DOC, EPD, ET, GEO, HASI, IRM, KNOP, O, OHI, SBRA, STWD, VTR, WELL, WES
by: D.S. Leach & C.E. Leach
Summary

The new Federal tax legislation passed in 2017 not only provides lower tax brackets but also a pass through deduction for some classes of business income.

The qualified business income deduction applies to ordinary REIT dividends and MLP income distributions as well as self-employed contractors.

This article provides a brief summary of how taxpayers will benefit from the new tax legislation and some benefits investors will not want to pass up.

Introduction

The tax cut legislation of 2017 was passed with no House or Senate Democrats supporting the bill. The bill was passed on a straight party line vote. I find this odd, given the Democrats had generally supported tax cuts for working folks in the past. While the 2017 tax package provided tax relief for nearly all taxpayers, the lower and middle class wage earners will soon see that their tax liability in 2018 is significantly lower compared to 2017.

In addition to lowering most people's tax liability for 2018, many small business owners, partnerships, sole proprietors, and independent contractors will benefit from the new Qualified Business Income (QBI) pass through deduction of up to 20%. This QBI deduction also applies to pass through income from REITs and MLPs. Investors will be getting a better return from their pass-through investments in 2018 and going forward.

Tax Cuts and Jobs Act of 2017

There has been a great deal of sound bite information on the supposed impacts of the Tax Cuts and Jobs Act (TCJA), but I've seen little with respect to factual comparisons or honest thorough analysis. My personal view, considering the entire bill, is that it is beneficial to both individual taxpayers and business. The TCJA made fairly broad changes to the previous tax code.

Major elements of those changes included a reduction in marginal tax rates for both business and individuals, increasing the standard deduction, increasing child care tax credits, eliminating personal exemptions, capping the deduction for state and local taxes [SALT] to no more than $10,000, and further limiting the mortgage interest deduction. These changes make it somewhat less advantageous, from a tax perspective, to have a large family due to the trade-off between personal exemptions versus increasing the standard deduction and child care tax credits. The TCJA also made it more expensive to live in a state with high income and/or real estate taxes due to the $10,000 cap on the SALT deduction.

I've done several comparisons between the old (2017) tax code and the new (2018) tax code for individual income taxes, and I'm fairly well convinced that the majority of taxpayers will be better off under the TCJA. A simple comparison shown in the table below shows why I hold that opinion. The table below shows the Federal tax liability for a family of three, two adults filing a joint return with one dependent at various levels of income and using the standard deduction.

Source: Author

I look at this data and conclude that everyone got something. Others look at this data and conclude that the low and middle income taxpayers got the shaft and the wealthy taxpayers got a big tax cut. In absolute dollars, high income taxpayers did get a larger tax reduction but on a percentage change basis, the low and middle income taxpayers got a better deal. See the chart below.

Source: Author

Was it necessary to provide tax relief for those with $500,000 plus in taxable income or to continue with the carried interest tax break for hedge fund managers? Probably not. But, on whole, the TCJA appears to be beneficial to most taxpayers.

Another benefit that flows down to the heirs of larger estates is the increased exemption amount below which estates pay no Federal estate tax. The TCJA increased the estate tax exemption to $11.2M in 2018, and it was also indexed for inflation. A couple could potentially exempt $22.4M from the Federal estate tax with proper planning. I have always viewed the estate tax as nothing more than confiscating property that belongs to private individuals, so I'm happy to see these changes.

The TCJA also provides a deduction of up to 20% for qualified business income from sole proprietorships, partnerships, S-corporations, and LLCs or LLPs that are taxed as partnerships. Since I'm currently working as an independent contractor, and I should be able to deduct 20% of my business income from my adjusted gross income before taxes, I am really liking section 199A of the TCJA. There are some income limitations on the 20% deduction for two types of businesses:

  • 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, 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 owners or employees.
  • businesses involving the performance of services that consist of investing and investment management, trading, or dealing in securities or commodities.

The limitations on these two categories of business are income limitations that result in a phaseout of the 20% QBI deduction at higher income levels. Readers should note that engineering services and architectural services are specifically excluded from the list of "service businesses not qualified". For those wanting to read in more detail the provisions of section 199A of the TCJA, readers can find more complete presentations here and here.

Of particular interest to investors are the provisions in section 199A governing the tax treatment for ordinary dividends paid by REITs and income distributions paid by MLPs. REIT distributions typically come in three different flavors.

  • Ordinary Dividends - this is the most common form that results from the REIT paying out to investors roughly 90% of its taxable income. This type of distribution does not qualify for the 15% or 20% Federal tax rate applicable to "qualified dividends" from income that has already been taxed once at the corporate level as is the case with most non-REIT corporations.
  • Qualified Dividends - this type of distribution results from income that has already been taxed once at the corporate level. Qualified dividends "qualify" for the special 15% or 20% Federal income tax rate.
  • Capital Gain - REITs can choose to either hold or distribute its long term capital gains. If the REIT chooses to distribute the capital gain to its shareholders, it will be taxed at the investor level at the preferential long-term capital gains rate.

The 20% QBI deduction from section 199A of the TCJA will apply to REIT distributions classified as Ordinary Dividends but not to distributions classified as Qualified Dividends, Capital Gains, or Return of Capital.

Likewise, ordinary income from MLPs will be considered as QBI, and the 20% deduction would apply. As I understand the 199A provisions on MLPs, ordinary income from operations, as well as ordinary income generated from the sale of partnership units, is considered QBI and will qualify for a 20% deduction. For more detail on the tax treatment of REITs and MLPs under the new section 199A of the TCJA, interested readers can go here.

Finally, to clarify any questions about where this QBI deduction will be taken on the tax form, it is not a Schedule A deduction but is taken as a deduction essentially in series with the Schedule A (Itemized Deductions) or the Standard Deduction. So, the taxpayer need not itemize in order to benefit from the 20% QBI deductions.

TCJA Impact on REIT and MLP Investments

It is unclear to me whether investors have digested and understood how the TCJA benefits REIT and MLP ordinary income distributions. It is also unclear whether REIT and MLP valuations reflect the new tax treatment of their distributions. I'd really like to hear from readers via comments to this article as to whether or not the 20% QBI deductions for REIT and MLP ordinary income distributions are already well understood and therefore likely already reflected in REIT and MLP valuations.

I currently hold a significant number of REITs and MLPs in my personal portfolio. As of today, I hold Chatham Lodging Trust (NYSE:CLDT), Physicians Realty Trust (NYSE:DOC), Enterprise Products Partners (NYSE:EPD), Energy Transfer (NYSE:ET), The GEO Group (NYSE:GEO), Hannon Armstrong Sustainable Infrastructure Capital (NYSE:HASI), Iron Mountain (NYSE:IRM), KNOT Offshore Partners (NYSE:KNOP), Realty Income (NYSE:O), Omega Healthcare Investors (NYSE:OHI), Sabra Health Care REIT (NASDAQ:SBRA), Starwood Property Trust (NYSE:STWD), Ventas (NYSE:VTR), Welltower, (NYSE:WELL), and Western Gas Partners (NYSE:WES). The only holding I may sell out of this list in the near term is CLDT (a hotel REIT) since I believe the economic growth cycle is getting bit old and we could see a drop-off in business travel in the coming quarters. All of the other holdings in the list above I would recommend as long-term income investments.

Disclaimer: This article is intended to provide my opinion to interested readers and to serve as a vehicle to generate informed discussion in the comment postings. I have no knowledge of individual investor circumstances, goals, portfolio concentration or diversification. Readers are strongly encouraged to complete their own due diligence on any stock, bond, fund or other investment mentioned in this article before investing.

Disclosure: I am/we are long CLDT, DOC, EPD, ET, GEO, HASI, IRM, KNOP, O, OHI, SBRA, STWD, VTR, WELL, WES. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.