3 Ways to Maximize the Pass-Through Deduction

If you aren’t familiar with the Tax Cuts and Jobs Act (TCJA), you might be surprised to learn of a particular beneficial deduction.

The pass-through deduction, or qualified business income deduction, allows landlords to deduct up to 20% of their net rental income from their income taxes. 

The pass-through deduction helps landlords save hundreds of dollars on taxes and reduce their effective income tax rates.

However, this deduction has requirements, rules, and procedures, so you need strategies to use this deduction effectively.

Here are three ways to maximize the pass-through deduction next tax season.

What is the Pass-Through Deduction?

The pass-through deduction, also known as the qualified business income deduction or QBID, is a deduction outlined by the TCJA in 2018.

So, how does the pass-through deduction work? To use this deduction, you must meet one of two sets of criteria: either the regular requirements or the safe harbor requirements.

The regular requirements are as follows:

1. Run a for-profit rental business.

2. Run a pass-through business.

3. Generate qualified business income.

Occasionally, the assessment of these qualifications can get confusing for landlords who own multiple units and properties. If this  applies to you, then you can use the safe harbor requirements. If you meet the following safe harbor criteria, you automatically qualify for the pass-through deduction:

1. Keep records detailing your income and expenses for each rental enterprise you manage.

2. Contribute 250 hours of activity to your rental business each year (employees’ and contractors’ hours count toward the 250).

3. Keep records clearly demonstrating the services performed.

If you don’t meet the safe harbor requirements, no problem—you just have to meet the regular requirements to use the pass-through deduction.

Tip #1: Maximize Your Rental Income

The first tip for maximizing your pass-through deduction is to maximize your rental income. The pass-through deduction allows you to deduct 20% of your rental income, so the more income you have, the more you can deduct. 

One strategy you might consider is paying off some or all the debt you owe on the property. If a large portion of your rent payments are going toward mortgage payments each month, you won’t have a large profit to work with for the deduction.

Another strategy is to sidestep your depreciation deductions for the first few years you own your property. You can do this by avoiding cost segregation, bonus depreciation, or Section 179 expensing. 

Tip #2: Limit Taxable Income Under W-2/Property Thresholds

Another strategy is to keep your taxable income under the W-2/property phase-in figures listed by the IRS. 

Pass-through deduction amounts vary depending on your employees and their wages. Here are the figures currently in effect:

• For taxable income greater than $214,900 (single) or $429,800 (married filing jointly): you may only deduct the greater of 1) 50% of your employees’ W-2 wages, or 2) 25% of their W-2 wages plus 2.5% of your property’s unadjusted cost basis.
• If you don’t have any employees, the limit is 2.5% of the unadjusted cost basis.
• If 2.5% of your unadjusted cost basis 20% of your qualified business income or more, your deduction is still 20%; if it’s less than 20%, your deduction is capped at $2,500.

By knowing how the IRS calculates the deduction amount, you can work actively to keep your income in a favorable range. For instance, if your taxable income is $160,000 as a single taxpayer, you can secure the total 20% deduction.

Tip #3: Purchase a New Rental Property

Purchasing a new property increases your unadjusted basis, which will be multiplied by 2.5%. For this reason, acquiring a new property is a good strategy if you find yourself missing the income ranges you need to use the full deduction.

Another strategy is to hire new employees. However much you pay them, you can count 25% of their W-2 wages plus that 2.5% of the unadjusted basis. 

However, even if your new employees help you achieve a higher pass-through deduction, be sure your employees are still doing necessary, meaningful work. Otherwise, the IRS might question your deduction.

Conclusion

The pass-through deduction is one of the most complicated tax deductions for landlords. In fact, it would be impossible to understand every aspect of landlord taxes while maintaining your properties. But by doing your research and enlisting a tax professional when you need help, the pass-through deduction can save you hundreds on your next tax return.