What Is Qualified Business Income Deduction?

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Understanding personal taxes is crucial for individuals involved in real estate investment, freelancing, or owning an LLC. They also need to comprehend how their business operations impact their annual taxes owed to the IRS. In the US, many businesses fall under the “pass-through” category, where the business income is transferred to the owners and taxed through their individual returns. This applies to sole proprietorships, partnerships, LLCs, and S corporations, excluding C corporations. The Tax Cuts and Jobs Act of 2017 introduced the Qualified Business Income (QBI) Deduction, a significant tax relief provision for pass-through businesses. This article aims to explain the nature, eligibility criteria, and application procedure of the QBI Deduction for US taxpayers.

The QBI Deduction, or Section 199A, was added to the US tax code through the TCJA in 2017. It offers a potential tax benefit to businesses with pass-through income, allowing for a deduction of up to 20% of taxable income. To understand the QBI deduction, it is important to be familiar with two key terms:

  1. Qualified Business Income (QBI): QBI refers to the net amount of qualified items of income, gain, deduction, and loss derived from any qualified business or trade. This includes income from partnerships, S corporations, sole proprietorships, and certain trusts. The income must be connected to a trade or business within the US to be considered QBI. However, certain types of income, such as capital gains or losses, dividends, interest income, annuities outside of the business context, guaranteed payments from a partnership, and income earned overseas, are not considered part of QBI.
  2. Pass-through Income: Pass-through income is generated by a business and transferred to the owners, bypassing entity-level taxation. For example, the earnings of a sole proprietorship are not subject to corporate or business tax. Instead, this income is transferred to the proprietor, who is then taxed individually. Such businesses are referred to as pass-through entities.

The appeal of the QBI Deduction lies in its potential to allow business owners liable for self-employment tax to deduct up to 20% of their taxable income, reducing the federal income tax due for the year. Both standard and itemized deductions can qualify for the QBI. However, not all businesses are eligible for the deduction, and certain income thresholds must be considered. To qualify for the QBI deduction, one must fall into one of the following categories:

  1. Business owners with pass-through income: This includes sole proprietorships, partnerships, S corporations, and Limited Liability Companies (LLCs).
  2. Qualified REIT dividends or PTP income: Individuals with qualified dividends from Real Estate Investment Trusts (REITs) or income from Publicly Traded Partnerships (PTPs) are also eligible to claim a 20% QBI deduction. Qualified REIT dividends must have been held for more than 45 days and should not include capital gains or regular qualified dividends.
  3. Specified Service Trade or Business (SSTB): The QBI deduction is available only to owners of pass-through businesses. However, if the business falls under the category of an SSTB, the QBI deduction has specific limits based on taxable income. The limits change annually, so it can be helpful to work with a tax advisor to determine if the business qualifies for the QBI deduction. According to the IRS, an SSTB is a trade or business that involves services in fields such as 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. In other words, if the income of the business, typically a service business, depends on the owner’s abilities to perform a certain job, it qualifies as an SSTB.

Calculating the Qualified Business Income (QBI) deduction can be complex. Seek help from a tax expert or CPA. Here are the steps:

  1. Check if your business qualifies as an SSTB.
  2. Evaluate your total and taxable income. If below $170,050 for individuals or $340,100 for joint filers, you’re eligible for the full 20% deduction. If earnings exceed $220,050 individually or $440,100 jointly, you’re not eligible.
  3. SSTBs with income in the phase-out range need to calculate their QBI and apply the restriction based on W-2 wages or qualified property.
  4. Compare the resulting QBI to 20% of the surplus of your taxable income over your net capital gain.
  5. Claim the deduction by completing IRS forms 8995 or 8995-A. Find detailed instructions on the IRS website.

Regarding rental income, a “safe harbor” provision allows investors to qualify for the QBI deduction if rental activities are conducted as a trade or business under a rental real estate enterprise (RREE). Passive rental undertakings with minimal interaction with tenants do not qualify.

If you acquired a partnership interest in a real estate venture, your QBI deduction will be limited, and you’ll need to calculate the percentage of the unadjusted basis immediately after acquisition (UBIA).

Unlock Tax Savings: Invest in vacation rentals

The QBI deduction is a powerful tool for small business owners generating pass-through income. It’s crucial to understand it from both the business and tax savings perspectives, as well as in the context of your retirement planning. 

Explore our property listings available on this page and create an account to start your journey in vacation rentals investment today. Please note that these viewpoints are intended for informational purposes only and should not be considered as specific advice or recommendations for any individual or investment product.

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