Hello Everyone,
There is some confusion out there about how the new Section 199A tax deduction is calculated, particularly around the “Taxable Income” definition, which is the starting point for the entire calculation.
To clarify: Taxable Income is the starting point for your Section 199A deduction, and you can obtain that number from line 43 of your 2017 tax return. That number is comprised of far more than just your W-2 wages or business profit, it is adjusted for things like pre-tax retirement plan contributions and your standard or itemized deductions. The big factor I’d like to highlight in this article, is that Taxable Income also includes Capital Gains. Further, the Capital Gains number on your tax return impacts the actual formula that is used to determine your 199A deduction.
Refresher on the 199A Calculation: When your taxable income is equal to or less than the threshold of $157,500 (single) or $315,000 (married, filing jointly), your 199A deduction is the lesser of:
- 20 percent of your taxable income reduced by net capital gains, or
- 20 percent of your qualified business income plus 20 percent of your combined REIT dividends and qualified publicly traded partnership income.
The formula is more complex if your Taxable Income is above those thresholds, but for purposes of this post, I won’t get into all of that.
Here’s an example of how Capital Gains reduces your 199A deduction: Let’s say you are married and have taxable income of $300K for the year, but $100K of that is capital gains from the sale of an investment property. You also have are self-employed with qualified business income of $250K. So, you’ve grossed $350K for the year, but you have retirement contributions and a standard deduction that result in the Taxable Income number of $300K noted above. Since you are below the $315K taxable income threshold, your 199A deduction is calculated as the lesser of:
- 20 percent of your taxable income reduced by net capital gains: ($300K – $100K) x 20% = $40K
- 20 percent of your qualified business income: $250K QBI x 20% = $50K
While you’d normally get a $50,000 S199A deduction, the fact that you sold the investment property for a capital gain impacts the calculation, and reduced your S199A deduction to $40,000.
The Takeaway: It is important to keep an eye on large capital gain transactions if you qualify for the S199A deduction, as it can have a sizable impact on your tax bill. If you are considering selling a highly appreciated capital asset, please feel free to give us a call so we can assist in determining the full tax impact of the transaction, as well as work on ways to minimize that tax impact.
