In late January, Congress and the president enacted their new tax law. The new law effects “the most drastic changes to [the] US tax code in 30 years,” according to The Guardian. In previous posts, we discussed how these changes might affect the middle of the housing market in Texas and Colorado. Today we discuss how the “pass through” provisions in the new law might reduce tax bills for small-to-medium sized flipping and rental companies.

“Pass through” defined

If you are running a small-medium-sized flipping or rental business, chances are it is a “pass-through” business. A business is a “pass-through” if its income “passes through” to its owners for tax purposes. The business pays no taxes on its own return. Its return shows how much income (or loss) the business will add to (or subtract from) to the owner’s or owners’ returns. Pass-through businesses can take a number of different forms prescribed primarily by state law. These forms include sole proprietorship, limited liability company (LLC), professional service corporation, S corporation, partnership and limited partnership.

The change in law

The new law cuts tax rates for corporations to 21 percent. Absent a corresponding change to pass-through taxes, the change in corporate rates would have given corporations a significant tax advantage over pass-through structures. Seeking to level the playing field for non-corporate businesses, Congress also included pass-through provisions in the new law.

Very generally, the new law allows pass-through owners to deduct 20 percent of their pass-through profits from their income taxes. These business deductions are available regardless of whether the taxpayer claims the standard deduction or itemizes. But the new law also imposes a myriad of exceptions and qualifications limiting the new deduction. The most significant limits restrict the types of revenue included in calculating the deduction, the application of the deduction to higher-income taxpayers, and the application of the deduction to certain service businesses.

Revenue types

The new rules entirely exclude certain types of investment gains and income from the calculation of the deduction amount. Capital gains and dividends are excluded. Interest is as well, unless it is “reasonably allocable to a qualified trade or business.” The new law also excludes certain gains on trading in derivatives, commodities and other financial instruments.

Taxpayer income

The new law also includes a “wage limit” that reduces the deduction for pass-through companies that do not pay significant wages or own substantial physical property. The wage limit kicks in only for taxpayers with over $157,500 in taxable income ($315,000 for joint filers). The law refers to the income limits by a defined term: “threshold amounts.”

“Threshold amount(s)” reference the taxpayer’s total taxable income–as stated on the taxpayer’s tax return. This contrasts them from the “qualified business income” amounts that provide the basis for the calculation of the 20% deduction. (Compare 11th page under (3) with 12th page under (c).) “Qualified business income” refers to the income from the the pass-through business or businesses. “Qualified business income” will pass through to the taxpayer’s return and may well be less than the taxpayer’s total taxable income.

The law includes two separate phase-down provisions. The first is a pure “wage limit” applicable to all companies except “specified service” businesses. Generally, taxpayers with income below $157,500 of taxable income ($315,000 for joint filers) get the full 20 percent deduction on their pass-through income. For taxpayers above the threshold amounts, the pass-through tax cut phases down. The phase down continues over the income levels from $157,500-207,500 ($315,000-415,000 for joint filers). For taxpayers above $207,500 (415,000), the “wage limit” applies in full. That means taxpayers over $207,500 (415,000) will benefit only if their pass-through business(es) pay wages or own physical property.

“Specified service” businesses

“Specified service” refers to businesses such as lawyers, accountants, investment advisers and other financial-service providers. For “specified service” businesses, the new law sets the same “threshold amounts,” but applies a different phase down–or actually a phase out. The deduction from a “specified service” business phases out between $157,500-207,500 (315,000-415,000). It disappears completely if the taxpayer earns over $207,500 ($415,000 for joint filers).

Caveats and Disclaimers

You may have heard members of Congress and the administration describe this tax bill as a “simplification.” If you believe that, try to decipher the pass-through portion of the new law, found on the 10th-19th pages here. Or try reading over the conference report on the new pass-through rules. (See 543rd through 563rd pages of this document). Or try a more reader-friendly explanation of the new pass-through rules written by a journalist-tax lawyer. No matter what source you consult, the new rules are anything but simple. They are byzantine and confusing even if you are a tax accountant or lawyer. And the IRS will need to issue further guidance over the next several years to flesh out the rules, define terms, and address issues that arise. This guidance will make the pass-through rules even more complex. Under these circumstances, any analysis of how these rules apply to any particular business is preliminary and subject to change.

Further, the new law’s application to any business will depend on the particular circumstances. And we are not tax specialists. Please consult your tax accountant or lawyer if you have any doubt about how these changes apply to you. (And it’s hard to imagine how you wouldn’t.)

Application to flipping and rental companies

Disclaimers issued, it’s time to consider how the new pass-through rules might apply to flipping and rental businesses. At this early stage, a few key factors appear particularly salient on the topic.

Deduction applies to income, not capital gains

Flippers seek to profit by buying and selling houses. The tax code defines profit from buying and selling assets as capital gain–sometimes. For those in the flipping business, however, the code applies differently. “[T]he IRS classifies individuals who actively purchase and remodel real estate for profit on a continuing basis as dealers rather than investors,” writes Mike Slack of H&R Block. “For these people, the real estate is treated as inventory, rather than capital assets, and the profits on the sale of those properties is treated as ordinary income, subject to the self-employment tax.”

The definitions of “qualified business income” under the new law excludes excludes capital gains. (See the 13th page under (B), “Exceptions,” (i).) So only a flipping business reporting its profits as income will be eligible. Occasional flippers reporting their profits as capital gains on investments will receive no deduction from the pass-through law.

The deduction should apply to any rental income. The new law does not exclude rent from “qualified business income.”

Phase downs will probably affect some high-income flipping and rental companies

The phase down provisions of the new pass-through deduction will apply to many pass-through owners having incomes over $157,500 ($315,000 for joint filers). This includes high-income owners of flipping and rental companies. But whether the phase downs apply in a particular case depends on the company’s particular situation and how it accounts for its income and assets. The first phase down in the law–the pure “wage limit”–is particularly likely to apply to high-income owners of flipping and rental companies.

The first phase down involves a series of calculations. Four of those calculations are identified by letters in the new law: (A), (B)(i), B(ii) and (B). (See 10th and 11th pages.)

(A) equals 20% of the “qualified business income” from the business. “Qualified business income” is essentially the pass-through business’s income with exceptions and qualifications noted above.
(B)(i) equals 50% of the business’s W-2 wages.
B(ii) equals 25% of the business’s W-2 wages plus 2.5% of the value of the business’s “qualified property” at the end of the tax year. The definition of “qualified property” includes most physical property used to produce income for the business. (See 12th page.) For purposes of this calculation, the new law values “qualified property” at the time immediately after it was acquired, with no adjustments.
(B) is the greater of (B)(i) or (B)(ii).

The formula for the phase-down provision compares (B) to (A). If (B) is less than (A), the phase down applies.

On first look, it appears likely that a typical flipping business having income over the threshold amount would likely be subject to the phase down. In our experience, flipping companies tend to be relatively lean in terms of wages. In many cases, the company pays no wages at all or pays wages only to the owner(s). A flipping company may have significant inventory around at the end of a tax year in the form of houses held for resale. But part (B)(ii) of the formula multiplies inventory by a very small percentage–2.5%. So it would take a very large year-end inventory to offset 20% of a high income.

For instance, take a hypothetical successful and busy flipping company with $200,000 of income and $600,000 in property, mainly houses under rehab. (A) would by $40,000 ($200,000 x .2). Without wages, (B) would be (B)(ii), $15,000 ($600,000 x .025). So (B) would be less than (A), and the phase down will apply.

A rental business with a large portfolio may be in a better position to avoid the phase down under the formula. Take for instance a rental business with a $2 million portfolio, returning nine percent per year. Assume no wages. Part B(ii) of the formula would equal $50,000 (2,000,000*.025). Part A would equal $36,000 ((2,000,000*.09)*.2). Because (B) would be greater than (A), the phase down would not apply. These examples are admittedly oversimplified, but you get get the point. For a company with a high income, it takes significant wages and/or physical assets to make (A) less than (B) in the formula.

An owner might try paying wages to herself to drive number (A) down and numbers (B)(i) and B(ii) up. (The investor may need to have an S Corp. or elect to be treated as an S Corp. to do this.) Of course, reducing (A) may also decrease the amount of the deduction. The new law specifies that the “qualified business income” from a pass-through business does not include “reasonable compensation” paid to the taxpayer (owner) for services to the business. (13th page under (4).) So when wages go to the owner, the basis for the 20% calculation decreases. Still, paying oneself wages may increase a deduction under the new law in some instances, as shown in one of our hypotheticals below. Further, the owner may have other reasons to pay herself wages. For instance, it may help lower self-employment taxes. That is a discussion for another day, but definitely worth raising with your tax adviser if you have one.

In any event, some high-income owners of flipping and rental companies are likely to be subject to the phase downs under the new law. As such, it makes sense to consider how those phase downs operate.

Application of the phase down

The new pass-through rules include two separate phase down provisions. One is generally applicable to companies not in “specified service” businesses. A “specified service” business means legal, account, medical, financial services, actuarial sciences, performing arts, consulting, athletics. It can also mean any other business where “the principal asset . . . is the reputation or skill of one or more of its employees.” (See 553rd-554th page here.) The IRS is probably unlikely to characterize a typical flipper or rental-property owner as a “specified service” provider.

To recap, the phase downs apply to people with income levels between $157,500-207,500 ($315,000-415,000 for joint filers). They operate with reference back to calculations (A), (B)(i), B(ii) and (B) described above. For ease of reference, here they are again.

(A) equals 20% of the “qualified business income” from the business.
(B)(i) equals 50% of the business’s W-2 wages.
(B)(ii) equals 25% of the business’s W-2 wages plus 2.5% of the value of the business’s “qualified property” at the end of the tax year.
(B) is the greater of (B)(i) or (B)(ii).

Businesses not in professional services, financial services, or other “specified service(s)”

For non-“specified service” businesses, the phase down applies only if (B) is less than (A). The calculation breaks down into five not-so-simple steps. And that doesn’t even include the arithmetic necessary to come up with (A) and (B) in the bullet list above. Anyway, it works like this:

Take the taxpayer’s total income and subtract $157,500 ($315,000 for joint filers).
Take the result from step 1 and divide it by 50,000 ($100,000 for joint filers).
Referring back to the bullet list above, subtract (B) from (A) ((A)-(B)).
Multiply the result from step 2 by the result from step 3.
Take the result from step 4. Subtract it from (A). The resulting difference is your deduction.

For instance, let’s revisit our hypothetical successful and busy flipping company referenced previously. The company has $200,000 of income and $600,000 in property–no wages. To fill in the picture, the owner is a joint filer who together with his spouse has $350,000 of total income. The calculation works as follows:

(A) 40,000 (200,000*.2)

(B) 15,000 [B(i)=0(0*.5); B(ii)=15,000(0+600,000*.025)]

350,000-315,000=35,000
35,000/100,000=.35
(A) 40,000-(B) 15,000=25,000
.35*25,000=8,750
40,000-8750=31,250 (taxpayer’s deduction from the flipping business).

At taxpayer income levels above $207,500 ($415,000 for joint filers), the “wage limit” applies in full. Actually, this makes the calculation much simpler. The deduction from the pass-through business is the lesser of (A) or (B).

For example, return to our hypothetical above of a rental business with a $2 million portfolio, returning nine percent per year. To flesh out the example, assume that the taxpayer has $500,000 in total income, well over the threshold amount. Again, (A) would equal $36,000 ((2,000,000*.09)*.2). B(i) would be 0 (no wages). B(ii) would be $50,000 (2,000,000*.025). (B), the greater of (B)(i) or (B)(ii), would also be $50,000. The phase down would not apply because (B) would be greater than (A), and because the taxpayer would be well over $415,000 in total income. The pass-through deduction would be $36,000–the lesser of (A) or (B).

Businesses in professional services, financial services, or other “specified service(s)”

It appears unlikely that the definition of “specified service” businesses under the new law will ensnare many flipping or rental companies. Like we said, however, the law’s application is complicated and uncertain. So just in case, we’ll briefly run through the phase down for “specified service(s)” businesses.

The phase down for “specified services” businesses involves the same general concepts as the broader phase down. The “threshold amounts” are the same: the phase down applies to taxpayers with income over $157,500 (315,000 for joint filers). Also, like the general phase down, the “specified service(s)” phase down takes effect over the income levels between $157,500-207,500 (315,000-415,000).

The formula for “specified service” businesses operates differently, however. And the deduction phases out completely for “specified service(s)” businesses at $315,000 (415,000) of taxpayer income, regardless of wages or other factors. So the “specified service(s)” formula is not just a “phase down”; it’s a “phase out.”

Here is the phase-out formula for “specified service(s)” businesses:

Take the taxpayer’s total income and subtract $157,500 ($315,000 for joint filers).
Take the result from step 1 and divide it by 50,000 ($100,000 for joint filers).
Take 1 (or 100%) and subtract the result from step 2.
Take the lesser of (A) or (B).
Multiply the result from step 3 by the result from step 4. The resulting total is your deduction.

Take the flipping company from the hypothetical above: joint filers, $350,000 total income, $200,000 from a flipping company. Now assume that $120,000 of the joint income comes from a CPA firm owned by the wife of the flipping- company owner. The CPA firm is a pass-through professional service corporation. For starters, assume that the CPA provides the services herself and pays no wages. Assume further that the company has negligible physical property. The calculation for the CPA firm would work like this:

(A) $120,000*.2=24,000

(B) 0

350,000-315,000=35,000
35,000/100,000=.35
1.00-.35=.65
(B) is the lesser (0)
.65*0=0 (taxpayer’s deduction from the CPA business).

So in the CPA business would generate no deduction. Since our wife is a CPA who has studied the new rules, however, assume a slightly different hypothetical. Take the $120,000 in income from the CPA firm and divide it into $80,000 of income and $40,000 of wages. Now the calculation changes:

(A) $80,000*.2=16,000

(B) 20,000 [(B(i)=20,000 (.5*40,000); (B)(ii)=10,000 ((.25*40,000)+(.025*0))]

350,000-315,000=35,000
35,000/100,000=.35
1.00-.35=.65
(A) is the lesser ($16,000)
.65*16,000=10,400 (taxpayer’s deduction from the CPA business).

So splitting the income between profits and wages allows the taxpayer to claim a $10,400 deduction that would be unavailable otherwise. We have found nothing in the text of the law or the Committee report that would prevent the CPA from achieving this result by paying the wage to herself. This illustrates how it could make sense to ask your tax adviser about ways to structure your businesses and your income that could help maximize the new pass-through deductions.

Note also that in the final hypothetical, the joint filers could claim deductions from both the flipping business ($31,250) and the CPA business ($10,400). The text of the new law does not prohibit a taxpayer from claiming deductions from more than one pass-through business. And the examples in the conference committee report clearly indicate that Congress intended to allow more than one pass-through deduction. (See 559th page here.)

In summary, the new law will provide deductions for many flipping and rental companies

As discussed above, the new pass-through rules operate in a complex and arcane manner. But much of the complexity may not matter for the typical flipping or rental company. If you have a flipping company that reports its profits as income from a business rather than capital gains, you are likely eligible for a tax deduction based on the income from that business. And if your total taxable income is less than $157,500–or $315,000 if you are a joint filer–then the deduction will likely be 20 percent of your income from the business. The same applies to a rental business owned by a taxpayer whose income level falls below the threshold amounts. If your income level is over the threshold amounts, you are probably still eligible for some deduction based on the income from the business, but you will want to work through the amount with your tax adviser.

How changes in tax law for “pass through” companies might affect flippers and rental owners