*This article was originally written to reflect the new tax law in 2018, but was updated in January 2020 for your 2019 tax filing.
Our guest blogger today is Thomas Castelli, a CPA, Tax Strategist and member of The Real Estate CPA. Thomas gives us the rundown on how flippers can save thousands via the tax law in 2019.
We've heard a lot about the 2018 tax law and its effects on small business owners. One big takeaway: this tax law grants sole proprietors, partnerships, and S-Corporations a deduction called The Pass-Through Deduction, which allows business owners to deduct up to 20% of their qualified business income.
Good news for real estate investors: if you’re in the fix and flip business, it is very likely you conduct your business in one of the entity structures mentioned above and will qualify for this new deduction.
Today, we will walk you through this deduction and how it can potentially save you thousands in taxes.
The Pass-Through Deduction for Flippers
Flippers with Taxable Income Below $160,700 ($321,400 if MFJ)
If you’re a flipper that operates under a sole proprietorship, LLC, or S-Corp with taxable income less than $160,700 ($321,400 if married filing jointly, or MFJ), you will be able to deduct 20% of your qualified business income. Note: these taxable income thresholds apply to the 2019 tax year. For 2018, the amounts were $157,500 and $315,000 for single and married filing jointly, respectively.
Example
You are a single flipper with net operating income of $100,000 and W-2 wages of $50,000. Because you are below the $160,700 threshold, you will be able to deduct $20,000 from your net operating income ($100,000 x 20%).
Assuming you are in the 24% tax bracket, you will save $4,800 on your tax bill.
Flippers with Taxable Income Above $160,700 ($321,400 if MFJ)
If you’re a flipper with taxable income above these thresholds ($160,700/$321,400), things get a little more complicated, as W-2 wage limitations come into play.
Below are the rules and calculations to determine the pass-through deduction if your taxable income is above the phase-out thresholds (get ready to call your CPA!):
- Combined QBI Amount (in general) is the lesser of:
- 20% of the qualified business income with respect to the qualified trade or business, or
- The greater of:
- 50% of the W-2 wages with respect to the qualified trade or business
- The sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property.
- Qualified property is:
- Property which is held by, and available for use in, the qualified trade or business at the close of the taxable year,
- Property which is used at any point during the taxable year in the production of qualified business income, and
- The depreciable period for which has not ended before the close of the taxable year.
It is important to note that properties you hold with the intent to flip are considered inventory, and not qualified property for the purposes of these calculations.
Example
If your QBI is $470,000, your business has $100,000 in W-2 wages, and has qualified business property with an unadjusted basis of $50,000, your pass-through deduction will be the lesser of:
- $94,000 ($470,000 x 20%); or
- 20% of the qualified business income with respect to the qualified trade; or
- The greater of:
- $50,000 ($100,000 x 50%)
- 50% of the W-2 wages with respect to the qualified trade or business; or
- $26,250 (($100,000 x 25%) + ($50,000 x 2.5%)
- The sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property.
Your deduction in this example would be $50,000. Assuming you’re in the 35% tax bracket, you will cut your tax bill by $17,500.
The Bottom Line
While the new tax bill has a few other changes that will affect real estate investors, the Pass-Through Deduction will have the biggest impact for many flippers.
And due to the Pass-Through Deduction’s complicated calculation, it is recommended that you work with your CPA to determine how this deduction will impact your specific situation. Happy investing!
Author: Thomas Castelli, CPA is a Tax Strategist and member of The Real Estate CPA, an accounting firm that helps real estate investors keep more of their hard earned dollars in their pockets, and out of the government’s, by using creative tax strategies and planning. You can find him on LinkedIn.
