Earlier this month, a Tax Reform Toolkit post explained the basics of the new 199A 20% deduction for pass-through income. It focused on how the deduction works for a taxpayer who has less than $315,000 of taxable income, is married and filing jointly (or $157,500 in income if single).
In general, these taxpayers may deduct 20% of their pass-through income from their adjusted gross income before calculating their tax liability.
Individuals and families above these thresholds, however, must calculate their deduction using the W-2 wages paid to employees of, and the depreciable property held by, their business.
These wage and property rules are phased in between $315,000 and $415,000 in taxable income for married couples filing jointly (and half those amounts for single taxpayers).
But what happens if the limitations are fully phased in: the taxable income is greater than $415,000 for married filing jointly, or $207,500 for filing singly?
At these higher income levels, taxpayers must know three amounts before they can calculate their allowable deduction:
- W-2 wages paid to employees
- The prices paid for all depreciable assets owned by the pass-through
- Taxable income—defined as income less deductions except for 199A
With these in hand, the taxpayer can calculate the maximum allowable deduction using the following two methods:
Method 1. Multiply the amount of W-2 wages paid to employees (or your share of wages paid if you are one of multiple shareholders or partners) by 50%. Call this maximum allowable deduction ‘A’.
Method 2. Multiply W-2 wages paid by 25%. Call this amount (i). Add up the prices paid for all assets currently being depreciated (note this is done on a cost basis rather than using the value of assets after depreciation).
Now, multiply the cost of depreciable assets by 2.5%. Call this amount (ii).
Add (i) and (ii) and call the sum “maximum allowable deduction ‘B’.”
Now apply the “lesser of” rule, which states that your maximum allowable deduction is equal to the lesser of:
- The greater of A or B, or
- Taxable income multiplied by 20%.
Let’s take an example. Randy has $600,000 in qualified business income — representing all of his household’s income—and would ideally like to take a deduction equal to 20% of that, or $120,000. He also plans on taking $100,000 in itemized deductions.
In 2018, Randy’s pass-through business:
- Pays $200,000 in W-2 wages
- Owns $1 million of qualified depreciable property
Because he is above the income threshold, he must use methods 1 and 2 to calculate his maximum allowable deduction before applying the “lesser of” rule.
Because he has $600,000 in income and takes $100,000 in deductions, Randy’s taxable income for these purposes is $500,000. That means that his his 199A deduction may not exceed 20% of $500,000, or $100,000.
Fortunately, this does not further limit his allowable deduction, as his maximum 199A deduction allowed (A) is also $100,000.
In the end, Randy may deduct a total of $200,000 (itemized deductions plus 199A) from his adjusted gross income before calculating his tax liability. That means that rather than paying tax on $500,000 as he would have under prior law, he will pay tax on only $400,000.
The next Tax Reform Toolkit post will explain how to calculate the 199A deduction of a taxpayer whose annual taxable income falls within the phase-in range. For additional information, see this Eye on Housing blog post from NAHB economist David Logan.