As we have highlighted in previous articles and our webinar on the new “Qualified Business Income Deduction” (QBID), there are many unsettled questions about what qualifies for the new deduction. In passing the Consolidated Appropriations Act of 2018 on March 23, Congress has apparently closed the door to one opportunity – claiming the QBID for any gains resulting from the sale of property used in a trade or business.
The new section 199A provided a definition of “qualified business income” that was ambiguous about whether gains resulting from the sale of property used in a trade or business (“Section 1231 property”) would be eligible for the deduction.
The ambiguity resulted from the inclusion of the word “investment” in part of section 199A. Those who thought that Section 1231 property gains should have been included in “qualified business income” could point to Congress’ inclusion of the word “investment” as a modifier before discussing “short-term” and “long-term” capital gains as items which were not within the definition of “qualified business income.” If Congress meant to exclude Section 1231 property gains, they reason, Congress would not have limited that category to “investment” items.
In the Consolidated Appropriations Act of 2018, the word “investment” was removed – thereby making it clear that any item of capital gain or loss – whether investment or non-investment – is not to be considered when determining qualified business income eligible for the deduction. This would seemingly include Section 1231 property gains. So, when property used (this would include buildings and land) in a trade or business is sold for more than the original purchase price less any depreciation allowed or allowable, the gain resulting from the excess is not eligible for the QBID.
How does depreciation factor into this scenario? Remember that as depreciation deductions are claimed, which reduce business income, the adjusted basis of the property is similarly adjusted. If the property is personal property, Section 1245 recapture applies to cause the previous depreciation claimed to be subject to tax as ordinary income (up to the amount of the depreciation previously claimed). This recapture income is not long-term or short-term capital gains; therefore, it appears that such recapture income would remain eligible for the QBID. For businesses contemplating a sale or disposal of one or more significant assets (or the business itself), careful planning should be undertaken to ensure that tax benefits, including the QBID, are maximized.
For real property used in a trade or business, Section 1250 may apply to create ordinary income from excess depreciation deductions. This would also appear to be eligible for the QBID. As Section 1250 rarely applies (as excess depreciation deductions are exceedingly rare) when real property used in a trade or business is sold, the gain is treated as a 1231 gain, and to the extent 1231 losses don’t exceed the gains, the net is treated as a long-term capital gain, and therefore ineligible for the QBID under the new law.
Under most circumstances, this limitation works against the taxpayer when it comes to the disposal of property used in a trade or business. A business is entitled to claim depreciation deductions for business property used in the business, for both real and personal property. Those depreciation deductions reduce the adjusted basis for determining gain or loss on that property; as that adjusted basis decreases over time, it becomes more likely that, if the item is sold, it will be sold at a gain. This is especially true of a group of assets that are part of a business which is sold at a premium. For taxpayers with property that is sold at a loss, however, the exclusion of such losses works to the detriment of the taxpayer. To the extent the net 1231 gains and losses net to a loss, the loss is treated as an ordinary loss and therefore reduces the qualified business income.
While taxpayers have been dealt a setback because of this recent change, there are still many opportunities for business owners to benefit from the QBID. Unfortunately for those selling business property, getting a 20% deduction from gains is not going to be one of them.
If you have any questions about the Qualified Business Income Deduction, contact John Venturella, JD, CPA, Brett Bissonnette, JD, CPA, or any of the other skilled tax professionals at Clark Schaefer Hackett.