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You are here: Home / Section 199A / Section 199A Changes Investment Portfolio Construction

Section 199A Changes Investment Portfolio Construction

June 4, 2018 By Stephen Nelson CPA

Sec. 199A investment changes

The new Section 199A “pass-thru” deduction mostly matters to sole proprietors, partnerships, S corporations and real estate investors.

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 final regulations that appeared in January 2019.

REIT Dividends Only 80% Taxed

A first change Section 199A potentially makes? You may now want to consider holding REITs  as well as REIT mutual funds 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:  The rule about taxpayer’s getting a Section 199A deduction for REIT mutual funds dividends doesn’t appear in the final regulations. The rule appears in proposed regulations released simultaneously with the final regulations for Section 199A.

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 roller coaster.

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 Section 199A deduction by $8,000 and could cut your federal income taxes by as much as $3,000.

Bump Your Rentals Activity to Achieve Safe Harbor Status

Initially many tax accountants thought (or hoped) that small time real estate investors would get the Section 199A deduction on their rental income.

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Technically, you can qualify for a 20 percent deduction if your real estate activities rise to the level of a Section 162 trade or business–something we discuss in more detail here: Section 199A Rental Property Trade or Business Definition. But basically that standard says you need to show continuity, regularity and a clear profit motive in your real estate business.

In the end, however, the Treasury and Internal Revenue Service tightened up the qualifications required to take the deduction on rentals. A plain reading of the official guidance now says you need to meet the Section 162 standard (so continuity, regularity and a profit motive)… and then you also need to do a bit more than that.

That vagueness creates risk and uncertainty. And can give rental investors heartburn.

Fortunately, you do have a possible way around this problem. You can use the Section 199A rental property safe harbor. The safe harbor requires you to spend at least 250 hours a year on your rentals doing specific types of work. (That earlier blog post referenced explains.)

Which naturally leads to this tactic: If you can’t hit 250 hours with your current property or properties,  you may just need to add another rental to your portfolio to push you over the 250-hour threshold.

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 Maybe Trumps Section 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 as much sense for high income taxpayers because they reduce or even eliminate the Section 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 Section 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: Though a like-kind exchange delays the point at which you pay income taxes, a like-kind exchange also reduces the original basis of the property as compared to a regular sale 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 Section 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 175 pages before you get to this complexity.)

Domestic Investments Not International

One final angle to consider: Section 199A applies to domestic income. Not foreign income. You want to consider that.

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For example, rental properties in Florida potentially create a Section 199A deduction. But an identical portfolio or properties 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-through entities like partnerships create a Section 199A deduction. But foreign pass-through 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:

199A Deduction: Calculating Your Tax Savings

Real estate investor Sec. 199A Deductions

S Corporation Shareholder Salaries and Sec. 199A Deduction

Sec. 199A Deduction Phase-out Calculations

Sec. 199A S Corporation Dissolution

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.

Maximizing Sec. 199A Deductions

Filed Under: individual income taxes, investment, personal finance, Section 199A

Reader Interactions

Comments

  1. Solo Prosperity says

    June 5, 2018 at 1:22 pm

    I may be confused on this still. Is the suggestion of avoiding retirement accounts based on keeping profits in a corporate investment account?
    I keep thinking that the debate is between a retirement account versus Sec 199A deduction + personal taxable account. Any clarification is great.

    If I am wrong disregard the below but the retirement account points seems to be missing a few notes.

    1. Investments grow tax-deffered in the retirement accounts while in a taxable account there is an annual tax drag on income and dividends (Are you saying the 199A deduction offsets this in a taxable account?). It seems as though the time horizon matters when you take this into account. Yes, you may lose the 199A deduction but the tax-deferred growth can add up over time. The shorter the horizon, the less of the benefit of tax-deferred investment growth. I.e. When younger, take the retirement deduction, but as you approach retirement, focus more on the 199A deduction…at least this what I see.

    2. Money going into retirement accounts comes from your highest marginal bracket so you are always getting your deduction from your highest bracket when going in. When it comes out, depending on your spending needs, it could easily come out at a lower effective tax rate creative a tax arbitrage spread. Something to consider.

    3. 401ks typically provide better asset protection in comparison to a taxable accounts. This is hopefully never a issue, but it certainly is a small positive.

    • Steve says

      June 6, 2018 at 5:21 am

      So here’s the way I’m thinking about it using a very simple example:

      Say someone is married, self-employed, lives in a state with no income tax, and makes before their Sec. 199A deduction $75,000.

      In this situation, taxpayer gets a $15,000 Sec. 199A deduction (20% of that $75,000). That pushes their taxable income down to $60,000.

      At that income level, the person has roughly $17,400 of “space” left in the 12% tax bracket.

      That means that the taxpayer can earn up to $17,400 of qualified dividends and long-term capital gains and not pay any income taxes.

      So now look at two options… Say taxpayer has two choices. He can

      (a) have $500,000 in Vanguard US stock market index fund inside an IRA. That money produces about $10,000 of qualified dividends and long-term capital gains. Taxpayer is not taxed on that income yet. But he will be when he draws the money.

      (b) have $500,000 in Vanguard US stock market fund outside an IRA. That money again produces about $10,000 of qualified dividends and long-term capital gains. However because all of this money is within the 12% tax bracket tax payer gets taxed at 0% rate.

      The tax-free option beats tax-deferred option. Neither option burdens the taxpayer with tax in year 1. And the Vanguard account balance at end of year is same either way. But when taxpayer draws that $10,000 from tax-deferred account, he will pay income taxes on it.

      I think another way to say this same thing: In the sort of special case situation like that described above, no tax deferral occurs. It’s weird… the IRA *is* a tax deferred account… but as compared to the other account, IRA doesn’t actually defer taxes.

      And this important wrinkle: This is a special case situation. Not all self-employed folks will have the tax accounting work this way. Someone needs to be in a state with no state income tax, be earning investment income that’s taxed at the 0% tax rate (because person is in the 10% or 12% tax brackets) and have a big enough Sec. 199A deduction to make this investment income tax free.

      BTW, your point about the 401(k) being a safer place to store wealth is a really good one. Thank you for sharing that point. I would also generalize and say that there are lots of other subtle benefits to a taxable account and to a tax deferred account that someone would want to consider.

      • Solo Prosperity says

        June 6, 2018 at 11:25 am

        Thanks for the detailed reply. That makes more sense now (I was thinking along those lines but was struggling to put it together without the example).

        I guess I am still slightly confused as to the downside of ALSO taking the retirement account deduction. If that same individual placed $10,000 in a 401k, AGI is now $65k. Sec 199A deduction of $13k gets them to $52k AGI and so now they have $25.4k of room in the 0% bucket AND have money in a guaranteed tax-deferred account to protect against a scenario where there income goes up in the future.

        Say there income goes to $150k in 5 years, they would now have a larger taxable account that they are required to pay div/inc taxes on because they are above the 0% bracket now even with deductions.

        To be clear: I am definitely biased as I have always been taught to get as much $ as possible into tax-free/deferred accounts, and my own math has always proved this, so I am clearly struggling with this point.

        • Steve says

          June 6, 2018 at 4:43 pm

          There is a tax savings to putting that next $10,000 into a 401(k) account. In the example situation I described in the Sec. 199A changes retirement planning, it’s maybe $500-$550 a year. (That’s the tax deduction savings created by putting the deduction on your return.) It doesn’t seem super attractive to me. But it’s $500 or $550 “attractive”…

          Also, your math is probably correct for many investors. And before Sec. 199A it may have been correct for most investors or even all investors. It’s Sec. 199A that’s changing landscape for some taxpayers.

          • Solo Prosperity says

            June 7, 2018 at 9:30 am

            Got it. Seems that it reiterates the point of how complex these decisions become over time AND how each person needs to evaluate their own situation. I laugh every time a new law is supposed to simplify the tax process. Every new law seems to further solidify the need for experienced CPAs, especially for those that have any level of complexity beyond simple W-2 income.

            Thanks for the help.

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