For 2018-2025, you (and estates and trusts) can use your qualified business income (QBI) to create the 20 percent deduction under Section 199A.
While federal income tax losses from business activities are usually beneficial, losses from pass-through business entities can have the adverse side effect of reducing allowable QBI deductions for pass-through business entity owners– such as you.
In this context, pass-through entities are defined as sole proprietorships, single-member (one owner) LLCs treated as sole proprietorships for federal income tax purposes, partnerships, multimember LLCs treated as partnerships for federal income tax purposes, and S corporations.
These entities can pass through business losses that you can deduct in the current year. But a pass-through of a loss could harm your QBI for the current year.
Or you may have to suspend the losses and carry them forward to future years. The suspended losses can also result in negative QBI in the year you deduct them.
- Negative QBI from one source offsets positive QBI from other sources.
- If you have overall negative QBI for the year, you must carry forward the negative amount to future years to offset positive QBI in those years. That can result in lower QBI deductions in carry-forward years.
- The negative QBI issue is specially relevant now, since COVID-19 economic fallout will cause many pass-through business entities to pass through negative QBI amounts to their owners for 2020 and possibly for 2021 as well.
- You also may have suspended pass-through business entity losses from prior years that are now deductible, such as suspended passive losses from rental real estate properties that have been sold. Suspended passive losses can also be “freed-up” when you have passive income. Previously suspended losses can cause negative QBI in the year they become deductible.
This article explains the federal income tax impact of negative QBI, including negative QBI caused by deducting previously suspended losses.
We also suggest some planning ideas to get you better QBI deduction results in this scenario. Here goes.
You Have Overall Negative QBI
If a pass-through business entity owner, such as you, has an overall negative QBI for the year, your QBI deduction is zero. No surprise!
You then carry forward the negative QBI amount to the next tax year and treat it as negative QBI arising from a separate business in the carry-forward year. You carry forward any unused negative QBI amount indefinitely until it is finally used to offset positive QBI in a carry-forward year.
QBI Deduction Limitations
Your ability to benefit from a QBI deduction begins with your Form 1040 taxable income. If your Form 1040 taxable income is equal to or less than the threshold listed below, you qualify for the QBI deduction – period.
- For 2020, if your taxable income is equal to or less than $163,300 for unmarried individuals or $326,600 for married joint filers, your QBI deductions suffer no impediments.
- For 2021, if your taxable income is equal to or less than $164,900 for unmarried individuals or $329,800 for married joint filers, your QBI deductions suffer no impediments.
Once you exceed the threshold, you enter a phaseout of your QBI deduction. It works like this:
For the unmarried taxpayer, the phaseout is $50,000. When taxable income is greater than the threshold, say $164,900 in 2021, but less than $214,900 ($164,900 + $50,000), your QBI deduction phases out to zero at the upper level of the phaseout.
But if your pass-through business paid W-2 wages and/or has qualified property and it is not in a “specified service trade or business”, you can avoid suffering partially or totally from the phaseout because of the wages and/or property.
You might find this confusing, so let’s clarify:
- If your Form 1040 income is equal to or less than the thresholds, you qualify for the QBI deduction.
- If your Form 1040 income is in the phaseout range, your QBI deduction can suffer if you don’t have any pass-through wages or qualified property.
- If your QBI deduction comes from a specified service trade or business and your taxable income exceeds the threshold plus phaseout amount, your QBI deduction is zero.
- If your QBI deduction comes from a “non-specified service trade or business” and exceeds the threshold plus phaseout amount, you qualify for the QBI deduction only when you have wages and/or qualified property.
For some easy ways to see how these factors work, check out New 2020 Section 199A Calculator.
If you have overall negative QBI for a tax year, any W-2 wage amounts for that year and any investments in qualified property for that year are disregarded and are not carried forward to future years for purposes of applying the wage/investment limitation in those future years.
You Have Overall Positive QBI
If your own multiple interests in pass-through business entities, you must allocate any negative QBI amounts to the businesses with positive QBI in proportion to each business’s positive QBI if you have
- overall positive QBI for the year and
- negative QBI from one or more businesses.
The negative amounts are netted against the positive amounts. Any W-2 wages and investments in qualified property from businesses with negative QBI are disregarded and are not carried forward to future years for purposes of applying the wage/investment limitation in those future years.
Election to Aggregate Businesses for QBI Deduction Calculation Purposes
You (as a pass-through business entity owner) can elect on your personal return to aggregate businesses when calculating your QBI deduction if you meet specific requirements. Also, a pass-through entity with several businesses can elect to aggregate them. The aggregation election allows multiple businesses to be treated as a single aggregated business for QBI deduction calculation purposes.
When multiple businesses with positive and negative QBI are aggregated, the result is either
- a net positive QBI amount for the aggregated businesses, or
- a net negative QBI amount for the aggregated businesses.
Why make the aggregation election? Good question.
Aggregation can be beneficial when the wage/investment limitation on allowable QBI deductions is in play.
The advantage is that you can count W-2 wages and qualified investments from businesses with negative QBI when calculating the wage/investment limitation for the aggregated businesses if the aggregated businesses have net positive QBI.
But once the aggregation election is made, it is generally irrevocable.
Impact of Suspended Business Losses
Common examples of suspended business losses are losses that were disallowed for federal income tax purposes at the individual taxpayer level due to
- lack of basis in a partnership, LLC, or S corporation ownership interest,
- the at-risk rules,
- the passive activity loss (PAL) rules, or
- the excess business loss disallowance rules.
A suspended loss that otherwise would have been subtracted in calculating your QBI for the year in which the loss arose will reduce your QBI in the year when the suspended loss becomes deductible for federal income tax purposes. Until then, the suspended loss has no impact on your QBI calculation. When it becomes deductible, the suspended loss is treated as coming from a separate business activity.
When a suspended loss that arose in several different tax years become deductible, use the first-in-first-out (FIFO) method to identify which year the now-deductible loss came from.
Ignore Suspended Losses from Pre-2018 Tax Years
A suspended loss that arose in a tax year that ended before January 1, 2018, will not reduce your QBI when the loss becomes deductible.
For an individual taxpayer who uses the calendar year for tax purposes, we are talking about losses that arose in pre-2018 tax years. Since the QBI deduction did not exist for those pre-2018 years, a suspended loss that arose in one of those years (for example, in 2017) is not taken into account in calculating your QBI for the year when the suspended loss becomes deductible.
Don’t Ignore Suspended Losses from Later Tax Years
Say you have suspended business losses from 2018 and/or 2019. If those suspended losses become deductible in 2020 or a later year, they will reduce your QBI and thereby reduce your allowable QBI deduction for 2020 or that later year.
Say you have suspended business losses from 2020. If those suspended losses become deductible in 2021, they will reduce your QBI and thereby reduce your allowable 2021 QBI deduction.
Ignore Suspended Losses Not from Business Activities
Suspended losses that are not from a business activity, as defined by the QBI rules, do not affect your QBI calculation.
For instance, when you claim a current-year deduction for a net capital loss carried over from a previous tax year, the now-deductible capital loss does not reduce your QBI for the current year. IRS regulations specify the types of income, gain, loss, and deduction items that are taken into account in calculating QBI.
Treatment of NOL Deductions and Suspended Excess Business Losses
If you have a business net operating loss (NOL) deduction for the current year, it’s not taken into account in calculating your QBI for the current year. But if you have a disallowed excess business loss from a prior year that’s carried forward to the current year and deducted, it’s taken into account in calculating your QBI for the current year.
Impact of Suspended Rental Real Estate Losses
You may have rental estate losses from previous years that were suspended by the PAL rules. If so, you’re not alone. In the context of this analysis, the issue is: how will suspended passive rental estate losses affect your QBI calculation when those suspended losses become deductible?
The first thing to remember is that suspended passive losses that arose in a tax year that ended before January 1, 2o18, will never have any impact on your QBI calculation, as explained earlier. Good!
But suspended passive losses that arose in later years can potentially impact your QBI calculation when they become deductible. Here’s the deal.
You probably use the calendar year for tax purposes. Say you have suspended passive rental estate losses from 2018 and/or 2019. If those suspended losses become deductible in 2020 or a later year, they will reduce your QBI and thereby reduce your allowable QBI deduction for 2020 or that later year.
Say you have suspended passive rental real estate losses from 2020. If those suspended losses become deductible in 2021 or a later year, they will reduce your QBI and thereby reduce your allowable QBI deduction for 2021 or that later year. Not good!
The treatment of income and losses from rental real estate under the QBI rules is tricky. That’s because rental real estate activities are not automatically treated as businesses for QBI deduction purposes.
QBI Deduction Safe-Harbor Rule for Rental Real Estate
The QBI deduction is allowed only for income from a “business”.
The term “business” is not defined in the statutory language that created the QBI deduction. So, there was doubt about whether a rental real estate activity could count as a business for QBI deduction purposes.
In 2019, the IRS reacted by establishing a safe-harbor rule that allows you to treat a so-called rental real estate enterprise as a business for QBI deduction purposes. A “rental real estate enterprise” is defined as an ownership interest in real property held for the production of rents.
That’s all very good, but you may or may not want to use the safe-harbor rule that treats a rental real estate activity as a business. Keep reading to see why.
Treatment of Properties
Under the safe-harbor rule, the taxpayer must either
- treat each property held for the production of rents as a separate rental real estate enterprise, or
- treat all similar properties held for the production of rents as a single rental real estate enterprise.
The safe harbor considers commercial and residential rental properties as dissimilar, and you may not combine them.
But you can combine residential properties with other similar residential properties and combine commercial properties with other similar commercial properties.
Once you choose to combine similar properties into a single rental real estate enterprise, you must continue to treat interests in all similar properties, including newly acquired properties, as a single rental real estate enterprise if you continue to rely on the safe-harbor rule.
For rental real estate enterprises that have been in existence for less than four years, at least 250 hours of rental services must be performed each year in the enterprise. For enterprises that have been in existence for at least four year, the 250-hour test can be passed for any three of the five consecutive tax years that end with the current year.
Real estate that you use as a residence for any part of the tax year, such as a vacation home that you rent out for part of the year, is ineligible for the safe-harbor rule.
Real estate needed or leased under a triple net lease is also ineligible. A triple net lease is a lease agreement that requires the tenant or lessee to pay taxes, fees, and insurance, and to be responsible for property maintenance in addition to paying rent and utilities.
Separate books and records must be maintained for each rental real estate enterprise to keep track of the income and expenses. Certain contemporaneous records (including time reports, logs, or similar documents) must also be maintained.
Tax Return Statement Requirement
To use the safe-harbor rule for a tax year, you must include a statement with your timely filed Form 1040 for that year.
Tax Planning with and without the Rental Real Estate Safe-Harbor Rule
Each year, you can make the decision to use (or not use) the safe-harbor rule for a rental real estate enterprise (including similar properties that are combined and treated as a single property).
More specifically, if you meet all the aforementioned requirements for a real estate enterprise for the year, you can rely on the safe-harbor rule and thereby treat the enterprise as a business for QBI deduction purposes for that year.
If you have a rental real estate enterprise that produces positive net taxable income for the year, using the safe-harbor rule allows you to treat the enterprise as a business for QBI purposes, thereby including that income in calculating QBI for that year. That can result in a bigger allowable QBI deduction. Good! So, use the safe-harbor rule in this scenario.
If you have a rental real estate enterprise that produces a net taxable loss for the year, using the safe-harbor rule forces you to treat the enterprise as a business and thereby include the loss in calculating QBI for that year. That can result in a smaller allowable QBI deduction. Bad! So, don’t use the safe-harbor rule in this scenario.
For more on the safe harbor, see Will the Newly Released Section 199A Rental Safe Harbor Work for You?
For more on rentals as a business, see Good News: Most Rentals Likely Qualify as Section 199A Businesses
You already knew the QBI deduction rules were pretty complicated. No kidding!
Now you know the rules can be even more complicated when you have negative QBI for the year or suspended business losses from previous years that have become deductible.
Add another layer of complication if you have losses from rental real estate activities, including suspended losses from previous years that have become deductible.
All that said, however, with some thoughtful planning, you can use the QBI rules to achieve meaningful tax savings.