The Tax Cuts and Jobs Act - What it Means for Homeowners and Real Estate Professionals

Deduction for Qualified Business Income

Because the new tax bill greatly decreases the tax rate for corporations (from the prior law’s 35% to just 21%), many Members of Congress believed that the business income earned by sole proprietors, such as independent contractors, as well as by pass-through businesses, such as partnerships, limited liability companies (LLCs), and S corporations, should also receive tax rate reductions. In addition to lower marginal tax rates, the final bill provides a significant up-front (above the line^[1]) deduction of 20% for business income earned by many of these businesses, but with certain conditions.

Specifically, the bill limits the 20% deduction to non-personal service businesses. Essentially, a personal service business is one involving the performance of services in the following fields:

• Health, Law, Consulting, Athletics, Financial Services, Brokerage Services (not real estate), and “Any business where the main asset of the business is the reputation or skill of one or more of its employees or owners.”

With the inclusion of “brokerage services” it appeared at first that most real estate agents and brokers would be considered in a personal service business and would thus not normally qualify for the 20% deduction.

However, NAR was able to help secure a major exception in the final bill that makes it possible for many real estate professionals to be able to take advantage of the deduction.

• This exception provides that if the business owner has taxable income of less than $157,500 (for single taxpayers) or $315,000 (for couples filing jointly), then the personal service restriction will not apply.
• Above this level of income, the benefit of the 20% deduction is phased out over an income range of $50,000 for singles and an income range of $100,000 for couples^[2].
• For those with non-personal service income above these thresholds, the bill provides a second exception that may still allow a full or limited 20% deduction. This second exception (the wage and capital limit exception) places a limit on the deduction of the greater of:
  • 50% of the W-2 wages paid by the business, or
  • The total of 25% of the W-2 wages paid by the business plus 2.5% of the cost basis of the tangible depreciable property of the business at the end of the year.

Bottom Line: Independent contractors and pass-through business owners with personal service income, including real estate agents and brokers, with taxable income below the $157,500 or $315,000 thresholds may generally claim the full 20% deduction under the personal service income exception. Independent contractors and pass-through business owners with non-personal service income and total taxable income below these thresholds may also claim the full 20% qualified business income deduction. In addition, independent contractors (or other sole proprietors) with non-personal service incomes above these thresholds may also be able to claim a 20% deduction, but that deduction may be limited by the wage and capital limit exception.

However, at first it appeared that real estate brokers and agents with taxable incomes above the thresholds mentioned above would not be able to claim the new deduction.  Over months of letters, meetings, and discussions with Treasury and IRS officials, NAR was able to help convince the regulators to remove real estate agents and brokers from the term “brokerage services.”  Thus, the final regulations provide that real estate professionals may fully participate in the new deduction.

The following examples (detailed in the Appendix) illustrate how these new changes would affect different real estate professionals based on how their income is earned, income they may claim from a spouse, and how their business is structured. NAR members should consult a tax professional about their own personal circumstances.

Disclaimer:  These examples are for general information and education purposes only.  They are not offered as legal advice, legal opinion, or tax advice.  The U.S. Treasury Department requires us to inform you that these examples are not intended by NAR to be used, and cannot be used by any taxpayer, for the purpose of avoiding any penalties that may be imposed under the Internal Revenue Code. Discussion in these examples relating to federal tax matters may not be used in promoting, marketing, or recommending any entity, investment plan, or arrangement to any taxpayer.  Readers of these examples are advised to seek advice from a competent tax professional.

Example 1:  REALTOR® Amy is a single agent who operates as a sole proprietor and independent contractor.

Example 2: Assume the same facts as in Example 1 above, except REALTOR® Amy also had taxable pension income of $20,000.

Example 3: Carla and Bob Broker are married and file a joint tax return.

Example 4: Deborah is single and a high-producing real estate agent in an active market.

Example 5: Assume the same facts as in Example 4 above, except that Deborah has an employee whom she pays wages of $50,000 in 2018.

Section 179 Expensing

• The final bill increases the amount of qualified property eligible for immediate expensing from $500,000 (prior law) to $1 million. The phase-out limitations are increased from $2 million to $2.5 million.
• The final bill expands the definition of qualified real property eligible for section 179 expensing to include any of the following improvements to nonresidential real property placed in service after the date such property was first placed in service: roofs; heating, ventilation, and air-conditioning property; fire protection and alarm systems; and security systems.
• The bill also significantly increases the amount of first-year depreciation that may be claimed on passenger automobiles used in business to $10,000 for the year in which the vehicle is placed in service, $16,000 for the second year, $9,600 for the third year, and $5,760 for the fourth and later years in the recovery period.

Denial of Deductibility of Entertainment Expenses

• The final bill provides that no deduction is allowed with respect to:
  • An activity generally considered to be entertainment, amusement, or recreation;
  • Membership dues with respect to any club organized for business, pleasure, recreation or other social purpose, or
  • A facility or portion of a facility used in connection with the above items.
• Thus, the provision repeals the present-law exception to the deduction disallowance for entertainment, amusement, or recreation that is directly related to (or, in certain cases, associated with) the active conduct of the taxpayer’s trade or business.
• Taxpayers may still generally deduct 50 percent of the food and beverage expenses associated with operating their trade or business (e.g., meals consumed by employees on work travel).

Provisions Considered But Not Included in the Final Bill

Additional Withholding Requirements for Independent Contractors

• Language in the Senate-introduced bill would have subjected Independent Contractors to an additional 5% withholding requirement. This provision was dropped from the Senate (and final) bills.

Expansion of Unrelated Business Income Tax (UBIT) for Non-Profits

• The Senate introduced bill expanded UBIT treatment to include royalties derived from association licensing of trademarks or logos. This provision was dropped in the Senate (and final) bill. Additionally, tax writers considered subjecting certain exempt income (such as trade show or education revenue) to UBIT treatment but these provisions were not included.

Appendix 1 – Examples of How the Deduction for Qualified Business Income May Affect Various Real Estate Professionals

Example 1. REALTOR® Amy is a single agent who operates as a sole proprietor and independent contractor. She received $100,000 in net commission income in 2018. She has no capital gains or losses. After claiming deductions not related to her business, including the standard deduction, Amy’s total taxable income for 2018 is $81,000. Her qualified business income (QBI) is $100,000, which is her gross commissions less her business deductions. Amy’s section 199A deduction for 2018 is equal to $16,200, which is the lesser of 20% of her QBI from her business as a real estate agent ($100,000 x 20% = $20,000) and 20% of Amy’s total taxable income for the year ($81,000 x 20% = $16,200).

Example 2. Assume the same facts as in Example 1 except Amy Agent also had taxable pension income of $20,000, making her taxable income for the year $101,000. Her QBI is still $100,000. Amy’s section 199A deduction for 2018 is now equal to $20,000, which is the lesser of 20% of her QBI from her business as a real estate agent ($100,000 x 20% = $20,000) and 20% of Amy’s total taxable income for the year ($101,000 x 20% = $20,200).

Example 3. Carla and Bob Broker are married and file a joint tax return. Carla earns $50,000 in salary as an employee of Acme Corporation in 2018. Bob owns 100% of the shares of Bob’s Brokerage, which is an S corporation that provides real estate services and contracts with several agents. Bob’s Brokerage generates $100,000 in net income in 2018 after deducting Bob’s salary of $150,000. Carla and Bob have no capital gains or losses. After allowable deductions not related to the brokerage, Carla and Bob’s total taxable income is $270,000 ($50,000 salary for Carla + $100,000 net income from Bob’s Brokerage + $150,000 for Bob’s salary less $30,000 in deductions). Carla’s and Bob’s salaries are not considered Qualified Business Income (QBI). However, the net income from the S corporation is QBI. Carla and Bob’s section 199A deduction is equal to $20,000, the lesser of 20% of Bob’s QBI from the business ($100,000 x 20% = $20,000) and 20% of Carla and Bob’s total taxable income for the year ($270,000 x 20% = $54,000).

When Congress was debating the Tax Cuts and Jobs Act of 2017, it was not clear that personal services professionals like Amy and Bob would get much, if any, deduction for their business income. NAR, along with other organizations who represent small businesses, encouraged Congress to make the deduction available to as many small businesses and proprietors as possible. The result was that all sole proprietors and pass-through business owners below the taxable income thresholds of $157,500 for single filers and $315,000 for joint returns were made eligible for the deduction.

Example 4. REALTOR® Deborah is single and a high-producing agent in an active market. She is an independent contractor and sole proprietor of her business. She received net commission income of $400,000 in 2018. She has no employees, but owns business property consisting of her car and office equipment that originally cost $70,000. After allowable deductions unrelated to her business, Deborah’s total taxable income for 2018 is $370,000. Because her income exceeds the applicable threshold amount, Deborah’s section 199A deduction is subject to the W-2 wage and qualified property limitations. Her business has no W-2 wages, so the QBI component of Deborah’s section 199A deduction is limited to the lesser of 20% of the business’s QBI or 2.5% of its original cost of qualified property. 20% of her $400,000 of QBI is $80,000, and 2.5% of her original cost of her qualified business property is $1,750 ($70,000 x 2.5%).

Therefore, her section 199A deduction for 2018 is $1,750.

Example 5. Assume the same facts as in Example 4 above, except that Deborah has an employee whom she pays wages of $50,000 in 2018. Because her taxable income is above the threshold amount, Deborah’s section 199A deduction is subject to the W-2 wage and qualified property limitations. 20% of her QBI of $400,000 is $80,000. The W-2 wage limitation equals 50% of Deborah’s employee’s wages of $50,000 or $25,000. The original cost of qualified property limitation equals $14,250, the sum of 25% of the employee’s wages ($50,000) or $12,500 plus 2.5% of the original cost of qualified property ($1,750 - as above) is $14,250. The greater of the limitation amounts ($25,000 and $14,250) is $25,000. Deborah’s 199A deduction is limited to the lesser of 20% of the QBI ($80,000) or the greater of the limitations ($25,000). Thus, her deduction for 2018 is $25,000.

Note: Had Deborah paid more wages or had a larger investment in business property (owning the business’s office building, for example), the section 199A deduction could be much larger.

As enacted, the section 199A deduction provided that owners of certain businesses that provided personal services would be prohibited from claiming the deduction if their taxable income were over certain thresholds ($157,500 for single filers and $315,000 for joint returns). One of the prohibited types of business was “brokerage services.” Thus, it appeared that real estate agents and brokers would not be allowed to claim any section 199A deduction if their taxable income happened to exceed the threshold amounts. However, NAR advocated with the U.S. Treasury Department and the Internal Revenue Service, urging them to not include real estate professionals in the “brokerage services” category. The regulations, issued in January 2019, held that real estate brokers and agents would not be included in the prohibited category and thus would be eligible to claim the deduction no matter how high their incomes.

Appendix 2 – Examples of How The New Law Will Affect the Tax Incentives of Owning a Home

Example 1 - First-Time Homebuyer. To illustrate how the changes to the standard deduction, repeal of personal exemptions, mortgage interest and state and local taxes might affect a first-time homebuyer, consider the example of Barbara Buyer. Barbara, an accountant making $58,000 per year, is single and currently rents an apartment. She also pays state income tax of $2,900 and makes charitable contributions of $2,088, but the total of these is lower than the standard deduction, so she claims the standard.

Barbara’s tax liability for 2018 under the prior law is as follows:

Under the new law, Barbara would get a tax cut, computed as follows:

Tax Difference Under New Law. Even though Barbara would not get the benefit of the personal exemption under the new law, her higher standard deduction would more than make up for the loss. In addition, the lower tax rates of the new law would help deliver the total tax cut of $1,431 ($7,491 - $6,060) as compared with the prior law.

However, let’s take a look at what happens to Barbara if she were to purchase the condo that she likes costing $205,000. She takes out a 30-year fixed rate mortgage at 4% interest, putting down 3.5%. Assuming she buys early in 2018, her first-year mortgage interest would total $7,856 and she would pay real property taxes of $2,050.

As a first-time homeowner, her tax liability under the prior law would be computed as follows:

Note. Under the prior law, Barbara would lower her tax liability for 2018 by $2,098 ($7,491 - $5,393) by purchasing the condo. This is the financial effect of the prior law’s tax benefits of buying a home. This amount effectively lowers her monthly mortgage payment by $175 per month.

Now, let’s take a look at what her tax situation would be under the new law as a first-time homebuyer:

Tax Difference Under New Law. Even though Barbara would still be able to claim all of her itemized deductions under the new law, she would lose the benefit of her personal exemption. This would mean that her taxes would actually go up under the new law by $30 ($5,393 - $5,423). But far worse, look at the tax differential between renting and owning a home. This difference, which was $2,098 under the prior law, has now shrunk to just $637 ($6,060 - $5,423), or $53 per month. In other words, under the prior law, Barbara was given a strong incentive to move into the ranks of those who own their home. The new law still offers her an incentive, but it is a shadow of what it was, and is unlikely to be very compelling.

Example 2 - Middle-Income Family of Five:

To illustrate how the changes to the standard deduction, repeal of personal exemptions, mortgage interest and state and local tax deductions, and increase in the child credit might affect middle-income family of five, consider the example of Steve and Melinda. Steve is a store manager making $55,000 per year, while Melinda is a school principal, earning $65,000. They have three children, ages 17, 14, and 9. Steve and Melinda recently relocated from another city, and while they are getting to know their new community, they are leasing a home. But they would like to purchase as soon as they identify which area is the best fit for their family. As renters, they pay state income tax on their salaries, totaling $6,000, and also make some charitable contributions equaling $3,120. Since these itemized deductions do not reach the level of the standard deduction, they do not itemize, but they expect to do so when they purchase their home.

Here is a look at Steve and Melinda’s tax liability for 2018, computed under the prior law:

Under the new law, Steve and Melinda, as renters, would get a tax cut, computed as follows:

Tax Difference Under New Law As Renters. Steve and Melinda lose the big benefit of the personal and dependency exemptions for the two adults and three children. And the increase in the standard deduction is not enough to make up for this loss. However, the big increase in the child credit for the two younger children and the lower tax rate are enough to deliver them a tax cut of $2,371 ($11,370 - $8,999) as compared with the prior law.

Let’s now consider how Steve and Melinda’s tax situation changes if they were homeowners, rather than renters. Assume they find an ideal home in a nice neighborhood that costs $425,000, and after offering a 10% down payment, Steve and Melinda take out a 30-year fixed mortgage at a 4% rate. Let’s say that their real property tax for the year totals $4,250, which is just 1% of the home’s value.

Here is how their 2018 tax liability would be computed as homeowners, under the prior law:

Note. Under the prior law, Steve and Melinda would lower their tax liability for 2018 by $3,219 ($11,370 - $8,151) by purchasing their home instead of renting. This is the financial effect of the prior law’s tax benefits of buying a home. This amount effectively lowers their monthly mortgage payment by over $268 per month.

Now, let’s take a look at what her tax situation would be under the new law as a home-owning family instead of renters:

Tax Difference Under New Law As Homeowners. For Steve and Melinda, most of their itemized deductions from the prior law are preserved by the new law. They are limited slightly ($250) by the $10,000 limit on the deduction of state and local taxes. However, they lose big by the repeal of the personal and dependency exemptions, which equal $20,750 for this family. Even so, Steve and Melinda receive a small tax cut of $100 ($8,151 - $8,050) under the new law, thanks to the much larger child credit and lower tax rate. But as renters, they received a tax cut of almost $2,400. Thus, buying a home becomes a net tax change of almost $2,300.

What happened? What happened is that the new law is taking away most of the tax benefits of owning a home. Under the prior law, this benefit was $3,219 for Steve and Melinda. But under the new law, they enjoy only a benefit of $948 ($8,999 - $8,051). This gives them a benefit of just $79 per month, which is obviously a far weaker incentive to own.

[1] Meaning one does not have to itemize deductions in order to claim it.

[2] This means that for single individuals, the benefit of the deduction would be fully phased out for taxable income levels above $207,500 and for married couples filing joint returns, the benefit of the deduction would be fully phased out for taxable income levels above $415,000.