There are many complex and confusing aspects to the rules regarding the new 199A deduction, and the treatment of 1231 gains and losses are no exception.
Before we dive into these transactions as related to 199A, let’s begin at the beginning – what’s a 1231 gain or loss, anyway? In general, a Section 1231 asset is a depreciable asset or piece of real estate used in a trade or business for more than one year. Such assets could include manufacturing machinery, computers, a storage warehouse, etc. When pass-through entities such as partnerships or S Corporations sell a 1231 asset, the resulting gain or loss is passed on to the individual partners or shareholders to be reported on their individual tax returns. At that point, the individual is required to net all 1231 gains and losses – a resulting net gain is reported as a long-term capital gain and a net loss is reported as an ordinary loss.
So, now you’re probably wondering what all this has to do with the 199A deduction? Well, at its core, the 199A deduction is a 20% deduction of all qualified business income (known as QBI) reported by a taxpayer. There are various rules and limitations and the actual calculation can be quite complicated, but for our purposes here, let’s assume 20%.
For purposes of QBI, investment income, such as long-term capital gains, is not considered to be part of a taxpayer’s QBI. Section 1231 assets, however, are specifically excluded from the definition of a capital asset. So, while 1231 gains may be taxed as long-term capital gains, they are not gains arising from the sale of a capital asset, which would seem to imply that they should not be considered investment income for QBI purposes.
Unfortunately, the proposed regulations recently issued by the IRS arrive at a different conclusion. The regs state that a 1231 gain treated as capital is excluded from the calculation of QBI, meaning that such gains are not eligible for the 20% deduction. It doesn’t end there, though. The regs are inconsistent when it comes to the treatment of 1231 losses treated as ordinary – such losses will reduce a taxpayer’s QBI. This appears to place the taxpayer in a no-win situation. 1231 gains do not qualify for the 20% deduction, but losses will reduce the taxpayer’s income eligible for the 20% deduction.
Even more complexity and uncertainty can arise when a taxpayer has 1231 gains and losses stemming from multiple business activities, but if you weren’t dozing off a few paragraphs ago, you probably would be shortly. For more information regarding the 199A deduction, be sure to consult your trusted Henry+Horne tax advisor. We’ll keep you updated as we continue to navigate the new rules and regulations of the recent tax reform.
Austin Bradley, CPA