29 November 2021

Final Pass-Through Rules For Advisers

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The Treasury Department's new package of rules around the pass-through tax deduction is good news for financial advisers whose clients own rental property or invest in mutual funds that hold real estate investment trusts, according to tax experts.

But certain provisions, like one related to retirement plan contributions, may reduce the overall tax break that advisers and clients get.

"My overall reaction is, this is good," said Leon LaBrecque, an adviser and chief growth officer at Sequoia Financial Group. "They didn't give us everything we wanted, but almost everything we wanted."

The Treasury issued final regulations Friday afternoon around the pass-through tax deduction, a 20% tax break applied to pass-through business income that was created as part of the broad tax overhaul that President Donald J. Trump signed into law in December 2017. The deduction applies to businesses such as partnerships, S corporations and sole proprietorships whose income is taxed at the owners' individual tax rate.

The final rules, which follow proposed rules issued in August, created a safe harbor rule clarifying how clients can claim a tax deduction on profits from rental properties.

One key element, according to Jeffrey Levine, CEO and director of financial planning at Blueprint Wealth Alliance, is the requirement that owners, employees or independent contractors spend 250 hours on the property each taxable year.

"This is one of the big takeaways," Mr. Levine said. "I think this is the most important thing to come out that is new and materially different than the proposed regulations."

Activities that count toward the 250 hours include negotiating and executing leases, verifying information contained in prospective tenant applications, collecting rent, advertising to rent or lease the real estate, and managing the real estate, purchase of materials, and daily operation, maintenance and repair of the property. Activities such as procuring property, arranging financing, studying and reviewing financial statements, and traveling to and from the real estate don't qualify.

It may be difficult to reach 250 hours for a single property, but the rules allow taxpayers to bundle all like properties together, advisers said. Those with triple-net leases don't qualify for the pass-through deduction.

The Treasury also proposed more rules around the pass-through deduction Friday, including one that would benefit mutual-fund shareholders by clarifying that REITs held by funds are eligible for the 20% tax deduction — providing a tax windfall for shareholders. It was previously understood that REITs held outside of funds would get a tax break. 

"I think it changes a little bit of the algorithm, particularly as I see people getting more income-focused," Mr. LaBrecque said of investing clients' money.

At the same time, there was bad news for financial advisers and clients. For one, the final rules solidified that financial advisers and stockbrokers are "service" businesses who are ineligible for a deduction if their taxable income exceeds $207,500 (single filers) or $415,000 (married couples). Insurance agents and mortgage brokers, however, got an exemption from this requirement.

Further, the Treasury said the tax deductions business owners get for retirement plan contributions, self-employment tax and self-employed health insurance dilute the overall pass-through deduction. That's because those deductions would count against business income.

For example, a business with $100,000 of profits would grant the owner a 20%, or $20,000, tax deduction. If that business owner, however, had made $10,000 in retirement plan contributions, the deduction would only be $18,000 (which is 20% of $90,000).

"It's a haircut against the amount of income that qualifies," said Tim Steffen, director of advanced planning in Robert W. Baird & Co.'s private wealth management group. "It reduces the size of the deduction you can take."

Final rules also clarified another unfavorable point for business owners whose firms have multiple business lines — for example, a firm that sells eyeglasses and also offers optometry services, said Mr. Levine.

If the business line that counts as a "service" business (optometry, in this example) contributes more than 10% of revenues to the firm, then the entire business is ineligible for the pass-through deduction (if the owner's taxable income exceeds the aforementioned threshold).

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