In a nutshell, and subject to some very complicated rules, the deduction allows these folks to just “not pay” federal income taxes on the last 20% of business income they make.
Nevertheless , the new deduction does subtly impact investors, potentially changing the way investors construct their portfolios.
Specifically, I spot nine ways Section 199A scrambles (potentially) the construction of your and my investment portfolio.
Note: This blog post has been updated for the Section 199A proposed regulations that appeared in early August 2018.
REIT Dividends Only 80% Taxed
A first change Section 199A potentially makes? You may now want to consider holding REITs outside your tax-deferred accounts.
The reason? Section 199A also gives REIT investors the same benefit as it gives pass-thru business entities and real estate investors. REIT investors don’t have to pay income taxes on the last 20% of the dividends received from the REIT.
This new benefit probably isn’t a gamer-changer for most folks. The 20% discount, for example, means a taxpayer paying the 22% tax rate on her or his ordinary income pays instead 17.6% on the REIT dividends. (In comparison, this taxpayer pays 15% on long-term capital gains and qualified dividends.)
But that 20% discount is significant. Some taxpayers in special circumstances probably can logically now hold REITs outside of their tax-deferred accounts.
And remember this, to0: Those REIT dividends earned inside a tax-deferred account will be taxed eventually when the taxpayer withdraws them. At that point, the taxpayer will pay ordinary income tax rates on the REIT dividends.
Note: People hoped the proposed regulations, which came out in early August 2018, would say that folks investing in REITs through a mutual fund also get the Section 199A deduction. The regulations did not, however, provide that guidance. For now, investors should assume that REITs owned through a mutual fund or ETF don’t get the Section 199A deduction.
Qualifying Partnership Income Only 80% Taxed
Qualifying partnership income, like REIT dividends, also receives favorable tax treatment under the new law. Investors in one of these partnerships don’t have to pay income taxes on the last 20% of the partnership income.
I would say this “discount” means “partnership interest” investors should now hold these investments in their taxable accounts rather than in tax-deferred accounts.
You get the Section 199A deduction if you hold the partnership interest directly. And you avoid having to worry about preparing a 990-T tax return to report on unrelated business income taxes your IRA or 401(k) potential owes (something we talk about here: Self-directed IRA Real Estate Investment Problems and which you can learn more about here: IRS 990-T Instructions.)
Note: Let me also say here you need to exercise caution when investing in partnerships for the reasons discussed here: Partnership Tax Consequences: What Your Financial Adviser Didn’t Tell You,
Member Investments in Agricultural and Horticultural Cooperatives
The rules for how qualified agricultural and horticultural coop members treat their dividends have been, well, a rollercoaster.
Bad drafting of the initial version of the Section 199A statute probably meant these folks (farmers and ranchers) didn’t need to pay income taxes anymore.
The March 22, 2018 technical corrections to Section 199A fixed this nonsense (known as the grain glitch). But farmers and ranchers still face a very attractive tax planning opportunity via their membership in a qualified cooperative. If your business has this “investment” opportunity available, you want to closely look at how the new, technically corrected Section 199A deduction works. (We have a Section 199 technical corrections blog post that provides that information.)
Reallocation to Boost Qualifying Business Income
A special consideration that leveraged active investors may want to consider: You may want to change your asset allocation so as to boost your qualified business income.
Note: Qualified business refers to the income from unincorporated businesses, S corporations and real estate that gives you the 20% Sec. 199A deduction.
How you reallocate to boost qualifying business income depends on your portfolio’s specifics. But let me give you a very simple example to illustrate.
Suppose your portfolio consists of two assets: A $1,000,000 bank CD earning 4% interest. And a profitable rental property encumbered by a $1,000,000 mortgage costing you 4% interest.
In this situation, you can increase your qualified business by $40,000 if you cash in the CD and use that money to pay off the real property’s mortgage. That $40,000 increase in qualified business income should increase your Sec. 199A deduction by $8,000 and could cut your federal income taxes by as much as $3,000.
Avoid Taxable Income Limitation
The Section 199A deduction math includes a number of complexities based on taxable income. Most of these complexities don’t impact middle-class and upper-middle-class taxpayers.
One complexity does impact middle-class and upper-middle-class investors, however. Your Sec. 199A deduction may be limited to 20% of your taxable income taxed at ordinary income tax rates.
And when this limitation occurs–especially if the limitation regularly occurs–you may want look at reallocating assets and changing asset locations in order to boost the taxable income on your return.
For example, if your taxable income equals $70,000 and that amount includes $20,000 of long-term capital gains, your Section 199A deduction can’t exceed 20% of $50,000. That Section 199A deduction is still substantial at $10,000.
But if your taxable income equals $70,000 and that amount includes, say, $20,000 of qualified dividends instead, your Section 199A deduction can’t exceed 20% of $70,000. That Section 199A deduction equals $14,000.
Note that long-term capital gains and qualified dividends should be taxed at the same rate (either 0% or 15% in the above examples). So this change shouldn’t otherwise impact your actual tax bill.
Now obviously, your ability to tweak the taxable income input used in the Sec. 199A calculations depends on your balance sheet. But in some cases, avoiding the taxable income limitation might be as simple as holding “value” stocks paying dividends in your taxable account rather than “growth” stocks generating capital gains..
Reconsider Roth Accounts
We’ve pointed out in another blog post how Section 199A changes retirement planning. Many investors could consider abandoning, for at least the time being, using Roth accounts.
The notion behind this suggestion? If you’re getting a $10,000 or $20,000 Section 199A deduction, use that deduction to shelter the investment income earned on the money you could have invested in a Roth account.
For example, suppose someone earns $100,000 in a sole proprietorship and gets the $24,000 standard deduction because she or he is married. In this case, the taxpayer also gets a $15,200 Section 199A deduction pushing the household taxable income down to roughly $60,000 even with no other deductions.
In this situation, the taxpayer has roughly $17,000 of “space” in the 0% long-term capital gains and 0% qualified dvidends tax bracket. That means a taxpayer could have roughly $800,000 invested in something like the Vanguard total stock market portfolio–and not pay income taxes on that investment’s income.
See that other blog post if you’re intrigued. But I think Roth aficionados need to redo their analysis.
Double-check Math of IRA and 401(k) Accounts
For the same reasons outlined in the preceding paragraphs about Roth accounts, even traditional IRA and 401(k) accounts need to be reassessed, for investors with a large Section 199A deduction that pushes them into the 0% long-term capital gains and 0% qualified dividends tax bracket.
Partly, this need to reassess flows from the 0% tax bracket, as just discussed. The other problem, though, is that the retirement plan deduction isn’t as good a deal as in past because it decreases the Section 199A deduction the taxpayer receives. (This maybe wipes out 20% of the value of the retirement plan deduction in common cases.)
Consider this degradation of the retirement plan deduction and then look at the other “bad” things that happen with a retirement account–required minimum distributions, early withdrawal penalties, loss of foreign tax credits, and conversation of preferentially taxed income to ordinary income–and the case for a traditional IRA or 401(k) account weakens.
Just to make this clarification: Many self-employed taxpayers should still go with a regular IRA or 401(k). But some arguably should not.
Section 199A Trumps Sec. 1031 Like-kind Exchange
An “asset class specific” change to the old “traditional” investment rules: You need to reconsider your use of Section 1031 like-kind exchanges as a tax planning technique.
In many cases, these like-kind exchanges no longer make sense for high income taxpayers because they reduce or even eliminate the Sec. 199A deduction investors enjoy.
The math beyond this limitation gets complicated. But in a nutshell, some high income taxpayers investing in real estate get their Sec. 199A limited to an amount that equals the sum of 25% of the W-2 wages paid by a property investment plus either 0% or 2.5% of the original basis of the depreciable component of a property.
And here’s the problem: A like-kind exchange reduces the original basis of the property because of the way the tax accounting works. Further, a like-kind exchange also accelerates the point at which that 2.5% value drops to 0%.
The bottomline? You need to make sure you really understand both how Section 199A works and how Sec. 1031 works. You also need to make sure you compare the benefit of using Sec. 1031 to any reduction or loss of the Sec. 199A deduction. (A warning: You have to get into the Section 199A regulations about a 150 pages before you get to this complexity.)
Domestic Investments Not International
One final angle to consider: Sec. 199A applies to domestic income. Not foreign income. You want to consider that.
For example, a rental property in Florida potentially creates a Sec. 199A deduction. But an identical property in the Bahamas does not.
A domestic REIT creates a Section 199A deduction, but a foreign REIT typically does not.
Business income from domestic pass-thru entities like partnerships create a Section 199A deduction. But foreign pass-thru entities do not. You get the idea.
You may have great reasons to invest internationally. But be aware that a domestic equivalent investment may allow you to avoid income taxes the last twenty percent of the investment’s income.
Other Section 199A Information
If you want to learn more about the Sec. 199A pass-thru deduction, you may be interested in these other related posts:
Finally, if you’re a tax practitioner or other professional who needs to really understand how Sec. 199A works in order to serve clients, consider purchasing and downloading our Maximizing Sec. 199A Deductions monograph.