The Tax Cuts and Jobs Act introduced new Section 199A of the Internal Revenue Code (the Code), which provides individual taxpayers as well as certain other non-corporate taxpayers with a significant, though complex, deduction for qualified business income (QBI) from each of the taxpayer’s qualified trades or business, as well as a deduction of up to 20% of the aggregate qualified REIT deduction and qualified publicly traded partnership (PTP) income (click here and here for more). This complicated new provision left practitioners with a number of questions regarding its scope and application. In response to these concerns and requests for clarification, in August the Department of Treasury published proposed regulations in connection with Section 199A (the Proposed Regulations).
For direct and indirect owners of Real Estate Investment Trusts (REITs), the new Code provision may improve the already favorable tax treatment of this popular real estate investment vehicle (click here for more). REITs generally are treated as corporations for most federal tax purposes, but by complying with numerous income, asset, ownership and operational rules, and incur little to no corporate level tax. Further, from a shareholder standpoint, distributions from REITs generally are treated similarly to corporate distributions, which are treated first as taxable income to the extent of current and accumulated earnings and profits, second as return of capital to the extent of basis and therefore not subject to tax, and finally as taxable capital gain. In the case of the deduction available under Section 199A of the Code (the 199A deduction), the inclusion of “qualified REIT dividends” in the computation of combined qualified business income, may result in an increased 199A deduction in an amount equal to 20% of a taxpayer’s qualified REIT dividends (click here for more).
The Proposed Regulations address REIT-specific issues, such as the definition and determination of qualified REIT dividends, basic computational rules, and carryover loss rules.
Qualified REIT Dividends Defined
Section 1.199A-3(c)(2) of the Proposed Regulation defines “qualified REIT dividend” generally as any dividend from a REIT received, directly or through a relevant pass-through entity (excluding income earned from a PTP), during the taxable year that (1) is not a capital gain dividend, as defined under Section 857(b)(3) of the Code, (2) is not qualified dividend income, as defined in Section 1(h)(11) of the Code (i.e. eligible for the lower 20% rate as non-REIT corporate dividends) and (3) is received with respect to stock that has been held for 45 days or more. Further, Section 1.199A-3(b)(2)(B)(ii) of the Proposed Regulations clarifies that qualified REIT dividends are not included in the definition of QBI and are therefore not subject to the same limitations that apply to QBI.
The amount of qualified REIT dividends a taxpayer receives is only part of a larger and more complicated equation. For purposes of computing the combined qualified business income, the sum of qualified REIT dividends and qualified PTP income is added to the QBI to determine the allowable deduction. In general, the allowable deduction is the lesser of: (a) 20 percent of the taxpayer’s QBI, plus 20 percent of the taxpayer’s qualified REIT dividends and qualified PTP income and (b) 20 percent of the taxpayer’s taxable income minus net capital gains.
If the taxpayer’s taxable income is above the $315,000 (for married couples filing jointly) or $157,500 (for all other taxpayers), the deduction may be limited based on other factors relevant to QBI, including whether the business is a specified service trade or business that is not entitled to the deduction, as well as the W-2 wages paid by the business and the unadjusted basis of certain property used by the business (which otherwise are part of the QBI computation and qualification – see here). These limitations are phased in for taxable income between $315,000 and $415,000 for joint filers and between $157,500 and $207,500 for all other taxpayers, as adjusted for inflation in subsequent years.
Therefore, as the deduction is phased out, the impact of qualified REIT dividends may differ (as it also may depending on the ratio of taxable income to such dividends). The “lesser of” formula thus is more complex than it may first appear.
The Proposed Regulations helpfully provide examples clarifying how to calculate the 199A deduction when a taxpayer receives qualified REIT dividends. The following example is a simplified version of Example 4, found in Section 1.199A-1(c)(3) of the Proposed Regulations. If two married taxpayers are filing jointly, with income of $270,000 (below the $315,000 threshold), QBI of $100,000 (included in $270,000 of income), and qualified REIT dividends of $1,500, the married taxpayers would be entitled to deduct $300 more than if the married taxpayers only had QBI. Under these facts, the married taxpayers would be entitled to a 199A deduction in the amount of $20,300, the lesser of (i) 20% of the QBI ($100,000 x 20% =$20,000), plus 20% of the qualified REIT dividends ($1,500 x 20% = $300) and (ii) 20% of the married taxpayers’ total taxable income for the taxable year ($271,500 x 20% = $54,300). By comparison, under a similar scenario without qualified REIT dividends, the married taxpayers would only be entitled to a $20,000 deduction, the lesser of (i) 20 % of the QBI ($100,000 x 20% = $20,000) and (ii) 20% of the married taxpayers total taxable income for the taxable year ($270,000 x 20% = $54,000).
Importantly, the computation for qualified REIT dividend remains the same regardless of whether a taxpayer has income that is within the phase-in-range or exceeds the income threshold. The computation of QBI does change depending on a taxpayer’s income. In addition, the value of the qualified REIT dividends in the overall equation can vary due to the aggregation with the net qualified PTP income received, as discussed in further detail below.
Carryforward Loss Rules
Prior to the issuance of the Proposed Regulations, it was unclear what would occur if a taxpayer’s combined qualified REIT dividend and qualified PTP income were equal to an amount less than zero (because a loss from a PTP exceeds the sum of the qualified REIT dividend and other PTP income). Specifically, practitioners awaited guidance as to whether (i) the loss should be netted against the net positive QBI in the same taxable year as the loss occurred, thereby reducing or eliminating the benefit of the 199A deduction for such year, or (ii) eliminating the qualified REIT dividend and qualified PTP income in the current year, carrying forward the loss to subsequent tax years (but otherwise not affecting the current year 199A deduction). Section 1.199A-1(d)(3) of the Proposed Regulations, makes clear that for purposes of Section 199A of the Code, when the computation for combined qualified REIT dividends and qualified PTP income results in an amount less than zero for the taxable year, the negative amount is not netted against other current year QBI, but rather must be carried forward and used to offset the combined amount of qualified REIT dividends and PTP income in the subsequent taxable year. Note that this carryover rule does not affect the deductibility of the loss for purposes of other provisions of the Code.
Therefore, a taxpayer that receives qualified REIT dividends in 2018, but who reports a loss with respect to qualified PTP income greater than such dividend income will not benefit from the 20% deduction associated with the qualified REIT dividend. Further, the carryforward loss will reduce the deduction available in future years by offsetting the combined qualified REIT dividend and qualified PTP income in subsequent years.
Many had hoped that the Proposed Regulations would help bring clarity and simplicity to the computation of the 199A deduction and reduce compliance costs, which the IRS anticipates to be over $1 billion for the years in effect (2018 through 2026). Although the provisions specifically relating to qualified REIT dividends provide some clarity, the complexity with respect to 199A deductions remains and it is not clear that the Proposed Regulations significantly will reduce the financial burden of compliance.