(Surprised that you're getting the QBI deduction? Here's what might be going on.)
The Qualified Business Income deduction (also called the QBI deduction, pass-through deduction, or section 199A deduction) was created by the 2017 Tax Cuts and Jobs Act (TCJA) and is in effect for tax years 2018 through 2025.
With the QBI deduction, most self-employed taxpayers and small business owners can exclude up to 20% of their qualified business income from federal income tax (but not self-employment tax) whether they itemize or not.
The deduction amount depends on the taxpayer's total taxable income, which includes wages, interest, capital gains (etc.) in addition to income generated by the business. Once the taxable income reaches or exceeds $160,700 ($321,400 if filing jointly), the type of business also comes into play.
At incomes below that level, the deduction is 20% of either taxable income (minus capital gains and dividends) or the QBI, whichever is less.
At higher income levels, the deduction is reduced or eliminated, depending on the nature of the business. The calculations also get quite complicated, but TurboTax easily handles them and will figure out how much of a deduction you’re entitled to.
For the purposes of the deduction, QBI is defined as net business income, excluding:
- Income generated outside the United States
- Investment income
- W-2 compensation paid to an S corporation owner
- Guaranteed payments to a partner
- Income from REITs, publicly traded partnerships, and qualified cooperatives (these entities may qualify for a 20% deduction under a different set of rules, the explanation of which is beyond the scope of this FAQ).
This deduction applies to Schedule C filers (sole proprietorships and other self-employed businesses), LLCs, partnerships, S corporations, estates, and trusts. Certain rental enterprises may also qualify. Corporations are not eligible because they received their own tax breaks under the TCJA.
That said, not every eligible business automatically qualifies for the deduction. In particular, some types of service businesses (SSTBs) are disqualified once the taxable income on the return exceeds $210,700 ($421,400 if filing jointly).
The specified service trade or business (SSTB) classification doesn’t come into play as long as total taxable income is under $160,700 ($321,400 if filing jointly). At higher income levels, the deduction for SSTBs is reduced and in some cases, eliminated.
For the purposes of the QBI deduction, an SSTB is defined as any trade or business that performs services in the fields of:
- Actuarial science
- Performing arts
- Financial services
- Brokerage services (including investment management and investing, trading, or dealing in securities, commodities, or partnership interests)
Engineering and architecture were specifically excluded from the SSTB definition as it relates to this new deduction.
Rental real estate qualifying as a business for the QBI deduction
Starting in 2019, the IRS issued Revenue Procedure 2019-38 that has a safe harbor allowing certain interests in rental real estate, including interests in mixed-use property, to be treated as a trade or business for purposes of the qualified business income deduction.
If all the safe harbor requirements are met, an interest in rental real estate will be treated as a single trade or business for purposes of the deduction. If an interest in real estate fails to satisfy all the requirements of the safe harbor, it may still be treated as a trade or business for purposes of the deduction if it otherwise meets the definition of a trade or business.
More information can be found here.
Wondering if your line of work is considered an SSTB? Read more here.
OK, we’re kidding — sort of. For many TurboTax customers, the calculation is very simple, while for others…not so much. We’ve laid out the details below, but don’t worry if you find yourself getting lost — TurboTax easily handles the new QBI deduction and will let you know if you qualify and how much of a deduction you’re getting.
The deduction depends on the taxpayer’s total taxable income, which includes wages, interest, capital gains, etc. in addition to QBI. At higher income levels, whether or not the business is an SSTB will also play a role.
Under $160,700 ($321,400 if filing jointly): The calculation is straightforward — 20% is applied to QBI or taxable income minus capital gains and dividends (whichever is less) to come up with the deduction. It doesn’t matter if the business is an SSTB; the QBI deduction comes out the same.
For instance, a taxpayer with $30,000 of QBI, $100,000 in total taxable income, and $5,000 in capital gains would simply apply 20% to their QBI because it’s the lesser of the two amounts ($30,000 vs. $95,000). In this case, they’d get 20% of $30,000 for a $6,000 deduction.
$160,700 to $210,700 ($321,400 to $421,400 if filing jointly): Here’s where things get complicated. Let’s start with a fictitious example so you can follow along.
Jack and Jill are joint filers, and here’s the info they’ll need to calculate their QBI deduction:
- Total taxable income = $400,000
- QBI = $300,000 (and 20% of QBI = $60,000)
- W-2 wages paid = $50,000
- Unadjusted basis of qualified property = $800,000
- Their restaurant business is not classified as an SSTB
First, they calculate their reduction ratio (this is just a variable needed in the final calculation):
- Formula for joint filers = (Taxable income – $321,400) ÷ $100,000
- Formula for all others = (Taxable income – $160,700) ÷ $50,000
Because they are filing jointly, Jack and Jill’s reduction ratio = ($400,000 – $321,400) ÷ $100,000 = 0.786.
Next, they calculate their excess amount, which is another number they'll need for the final calculation. It starts with the greater of these 2 amounts:
- 50% of W-2 wages paid, or
- 25% of W-2 wages paid plus 2.5% of the unadjusted basis of qualified property.
For Jack and Jill, these 2 amounts work out to $25,000 and $32,500 respectively, with the $32,500 being the greater amount. To calculate their excess amount, they subtract the greater amount figure of $32,500 from 20% of their QBI ($60,000) to come up with $27,500.
Now, all they need to do is plug these numbers into final QBI deduction formula:
20% of QBI – (reduction ratio × excess amount) = QBI deduction
The QBI deduction for Jack and Jill’s restaurant business works out to:
$60,000 – (0.786 × $27,500) = $38,385
If Jack and Jill's business was classified an SSTB, for example a CPA firm or veterinarian practice, they would simply apply a special factor (1 minus their reduction ratio) to the previous result to calculate their QBI deduction:
$38,385 x (1 – 0.786) = $8,214
Phew! That was a ton of math, but if you happen to fall into this income bracket, rest assured that TurboTax handles this calculation with ease and in a lot less time than we took to explain it here.
Over $210,700 (over $421,400 if filing jointly)
SSTBs don’t qualify for the deduction, period.
For non-SSTBs, the deduction is either A or B, whichever is less:
- A = 50% of the business's W-2 wages paid (or 25% of the W-2 wages paid plus 2.5% of the business's unadjusted basis in all qualified property), whichever one is the greater amount
- B = 20% of QBI
If we borrow the numbers from Jack and Jill’s restaurant business (for illustration purposes only), their deduction would be the lesser of:
- A = $25,000 or $32,500 (whichever figure is greater, in this case $32,500), or
- B = $60,000.
Because A ($32,500) is less than B ($60,000), they get a $32,500 deduction.
If all of this sounds complicated, it is, at least when you get to the higher income levels. But the good news is TurboTax will take care of the calculations and let you know if you qualified and how much of a deduction you’re entitled to.