Should I form a Pass Through?

[Mr. Boh]

The new tax law has me thinking that I should form a pass through business to take advantage of the 20% deduction. I have been reading up on the subject yet I can't seem to fully conceptualize the best way to go about it or if it is even possible. It is my understanding that I could qualify for a pass through by forming a LLC or a sole proprietorship (DBA). When I spoke to my CPA he told me that as far as he knows a qualifying LLC would have to be a partnership and that I could not form a sole proprietorship with my circumstances (I am unsure why). Is it possible for me to form a pass through business without a partner? Any links to relevant articles would be appreciated.

Here is my situation:

I am FIRE, DW works and we have two kids. I have stocks and bonds. I have a $240k mortgage on my primary residence at 3%. I have two rental houses that are paid off. One is single family, one is a duplex, and the combined income is about $30k after expenses. Our yearly gross income is around $120k but changes quite a bit from year to year. I would be happy to go into it but it doesn't seem relevant to the question at hand.

I manage the rentals myself and try to do all the repairs and maintenance. Although revenue from rental income is considered "passive income" I spend a lot of hours every year dealing with these properties so it sure doesn't seem passive to me. It makes me wonder if I should somehow compensate myself for my time and reduce my rental income by increasing my expenses. This seems convoluted and unnecessary but maybe there is an angle to forming a business that I have not considered. Historically I have preferred to keep everything as simple as possible, but the thought of having a 20% deduction is seducing me to accept some complications. I am fine with the expense of setting up a LLC or DBA if it will save me five or six thousand dollars a year for the next eight years.

The rental property fits into my overall financial strategy by providing diversification because they are real assets that are (hopefully) less correlated to the gyrations of the stock market. Now there seems to be a different opportunity because the new tax law seems like it might be a gift to real estate owners. I should note that I'm not opposed to selling the single family rental house, paying off my home mortgage (which will no longer be tax deductible for me) and using debt to buy a multifamily rental house. In other words, I would be willing to scale up a real estate business if there were a good reason for doing it.


As you can see I don't have a clear idea of what to do. Many of the pieces don't necessarily fit together, but because of the new tax law, now seems like the time to evaluate them. Am I thinking about this the right way? Are my numbers off base? Can anyone here see a strategy that would be best for me?

[tralfamadorian]

The new tax law has me thinking that I should form a pass through business to take advantage of the 20% deduction. I have been reading up on the subject yet I can't seem to fully conceptualize the best way to go about it or if it is even possible. It is my understanding that I could qualify for a pass through by forming a LLC or a sole proprietorship (DBA). When I spoke to my CPA he told me that as far as he knows a qualifying LLC would have to be a partnership and that I could not form a sole proprietorship with my circumstances (I am unsure why). Is it possible for me to form a pass through business without a partner? Any links to relevant articles would be appreciated.

From everything I have read, your accountant is incorrect. The pass-through deduction includes both sole proprietors and single member LLCs. You do not have to make any changes to take advantage of the tax law. However, if your properties are paid off, it may be worthwhile to consider moving them to a LLC and operating your rental management business as a S corp for liability purposes.

Here is an article by our own @SeattleCPA  :
https://evergreensmallbusiness.com/sec-199a-qualified-business-income-deduction/

Especially check out the section "What is Sec 199A Qualified Business Income?" and the second paragraph. Personally, I found it useful to pull out last year's tax returns and compare my different schedules to those listed.

[SeattleCPA]

Agreed... Mr Boh doesn't need to do anything "special" to turn his rental income into pass-thru income. Income that appears on a Schedule C, E, and F is all pass-thru...

Also, just for sake of thoroughness, income that shows up in box 1 on a K-1 from a partnership 1065 or an S corporation 1120S or a trust or estate 1041 is also all pass-thru... so are some of the amounts shown in other K-1 boxes but not interest income, dividend income or capital gains income.

The thing that sole proprietors need to be alert to--but only if their taxable incomes are high--are the W-2 wages requirement and then the "specified service business" disqualification.

[Mr. Boh]

Thanks guys! I really appreciate your help.

SeattleCPA are you saying that I can file my schedule E the way I always have (including depreciation) and that income will be subject to a 20% deduction? I'm only asking this again and double checking because it almost seems too good to be true.

[SeattleCPA]

I think so. But I will tell you some people (smart, knowledgeable people) think differently.

The issue is whether your real estate activity rises to the level of a trade or business. And not to go too far into the weeds on this, essentially what these other tax folks are saying (worrying about, really) is that ultimately in order to enjoy Sec. 199A deduction you'll need to be involved in your real estate with the same level of intensity as is required to avoid the Obamacare net investment income tax.

This blog post explains *that* situation: https://evergreensmallbusiness.com/real-estate-investors-net-investment-income-tax/

[Mr. Boh]

Thanks SeattleCPA, you are the best!

[SeattleCPA]

Thanks SeattleCPA, you are the best!

:-)

[Dicey]

P2F

[kenmoremmm]

I think so. But I will tell you some people (smart, knowledgeable people) think differently.

The issue is whether your real estate activity rises to the level of a trade or business. And not to go too far into the weeds on this, essentially what these other tax folks are saying (worrying about, really) is that ultimately in order to enjoy Sec. 199A deduction you'll need to be involved in your real estate with the same level of intensity as is required to avoid the Obamacare net investment income tax.

This blog post explains *that* situation: https://evergreensmallbusiness.com/real-estate-investors-net-investment-income-tax/

so, if this is a grey area of the new code, what do you think turbotax will do (assuming we're e-filing using turbotax)? or, in order to take advantage of the new code, are we all going to need to hire CPAs?

[SeattleCPA]

I think so. But I will tell you some people (smart, knowledgeable people) think differently.

The issue is whether your real estate activity rises to the level of a trade or business. And not to go too far into the weeds on this, essentially what these other tax folks are saying (worrying about, really) is that ultimately in order to enjoy Sec. 199A deduction you'll need to be involved in your real estate with the same level of intensity as is required to avoid the Obamacare net investment income tax.

This blog post explains *that* situation: https://evergreensmallbusiness.com/real-estate-investors-net-investment-income-tax/

so, if this is a grey area of the new code, what do you think turbotax will do (assuming we're e-filing using turbotax)? or, in order to take advantage of the new code, are we all going to need to hire CPAs?

It isn't a gray area. The problem for all of us right now is, the law isn't really "complete" until the IRS writes Treasury Regulations to flesh out the details one needs to actually safely prepare tax returns and do tax planning.

As far as whether you need a CPA's help next year with the deduction, no, the software will easily take care of that... what you won't be able to do on your own is optimize the deduction. Too much complexity. Too much interaction with other chunks of the law, including for active trades or businesses "Subchapter S".

As an example of this, take a quick peek at the exchange of comments that Wile E. Coyote and I have on the second page of this thread:

https://forum.mrmoneymustache.com/taxes/pass-through-business-deduction/50/