What Are Section 199A Dividends?
You may have heard about a new tax deduction that pass-through entities and investors can take advantage of called the Section 199A deduction. But what exactly are Section 199A dividends and how do they play into this?
Section 199A dividends refer specifically to certain types of payments from real estate investment trusts (REITs) that qualify for the 20% deduction introduced under the Tax Cuts and Jobs Act of 2017. A REIT is a company that owns, operates, or finances income-generating real estate and passes on most of its income to investors in the form of dividends.
More specifically, Section 199A dividends include things like:
- Patronage dividends
- Per-unit retain allocations
- Qualified written notices of allocation
These are cooperative distributions that the REIT makes to its investors. The key thing that sets Section 199A dividends apart from regular REIT dividends is that they qualify for the tax deduction, regardless of your income.
So while other business owners have limitations on the 199A deduction, REIT investors can generally take the full 20% deduction on these special dividends up to their taxable income levels. Pretty sweet deal!
Tax Treatment of 199A Dividends
Now that you understand what Section 199A dividends are, you probably want to know how they are actually taxed.
The first thing to keep in mind is that Section 199A dividends, like regular dividends, still count as taxable income. You must include them just like any other dividend. The REIT will report these dividends to investors on Form 1099-DIV in Box 5.
However, once included in your taxable income, you then get to take the special tax deduction. This deduction allows you to take up to 20% of the amount of Section 199A dividends and reduce your taxable income by that amount.
Unlike qualifying business income which phases out at higher incomes, the 199A deduction for REIT dividends can be taken at any income level up to 20% of your total taxable income. And because these special dividends don’t count as “qualified dividends”, they are taxed at your ordinary income rate which makes the deduction even more valuable.
When it comes time to file your tax return, make sure to report your total dividends including the Section 199A amount on Form 1040 line 3b. Then you’ll need to file Form 8995 or Form 8995-A (depending on your situation) which will ultimately get picked up on Form 1040, line 13 for the deduction.
While the rules can seem complicated, the tax boost from Section 199A dividends is well worth taking the time to properly report them!
Calculating the 199A Deductions
Speaking of complicated rules, let’s take a minute to walk through how to actually calculate the different Section 199A deductions.
For context, remember there are 2 potential Section 199A deductions:
- The basic 20% of qualified business income
- The special 20% for REIT dividends
The qualified business income deduction has a few more hoops to jump through.
Here is a high-level process:
- Determine your total qualified business income
- Calculate taxable income
- Take 20% of whichever is lower between QBI and taxable income
There are also phase outs that kick in once your taxable income goes over $170,050 if single or $340,100 if married filing jointly in 2022. And you have to consider W-2 wage and property limitations if over those amounts. Lots to think about!
Comparatively, the Section 199A deduction for REIT dividends is super simple to calculate:
- Take your Section 199A dividend amount
- Multiple it by 20%
- Make sure it is equal to or less than your taxable income
Boom! Nice quick deduction when you have those special dividends from REIT ownership. No income phaseouts or wage/property limitations to worry about interfering with the tax savings.
As you tally up your total deductions between the different Section 199A sources, just confirm it does not exceed 20% of your total taxable income less capital gains. Then celebrate all those tax breaks!
Case Studies and Examples
Let’s take a look at few case studies and examples to see the power of the Section 199A dividends in action.
First, think about a farmer selling goods through a agricultural cooperative vs a independent non-cooperative buyer. For the sake of example, say he sold $300k of grain.
If selling to a co-op, he would receive a qualified patronage dividend that counts as Section 199A dividends. This would allow him to take a $60k deduction instantly without any income or wage/property limitations – providing huge tax savings!
On the other hand, if he sold through a private grain buyer for the same $300k amount, he would be dealing with qualified business income. After limitations based on taxable earnings and wages, he may get a deduction around $20k.
Big difference just based on the structure!
Or take an investor who owns shares in a retail REIT that pays a healthy dividend. Even a modest $2,000 Section 199A dividend could score them a $400 deduction to reduce taxable income thanks to the 20% reduction having no income limits.
Compare that to a law partner with over $500k in income from their S-Corp facing phased out QBI deductions and tough wage requirements, and you see the power here.
Whether farmers or investors, maximizing the 199A dividends are a great opportunity!
Open Issues and Future Guidance
The Section 199A deduction may be an awesome way to slash taxes, but it is not without uncertainties on how it ultimately gets interpreted and implemented.
Some key areas still needing clarification include:
- More guidance around definitions of terms like “principal asset”
- Potential changes in legal entity structures to maximize benefits
- Anti-abuse mechanisms giving the IRS more discretion
- Impacts on independent contractor arrangements
The deduction also starts to phase out completely in 2026 given the temporary nature added under the TCJA.
Early planning to take advantage where possible today is key! But also staying flexible as new rulings get introduced over the next couple years will ensure your long term tax strategy aligns with however Section 199A dividends ultimately shake out.
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While awaiting additional IRS guidance, here are 3 planning tips to make good use of Section 199A today:
1. Shift Specified Service Activities
If you have income from specified services exceeding income thresholds causing deduction limits, consider restructuring to isolate this income stream apart from your more tax favored streams. This can create opportunities to deduct otherwise phased out QBI amounts.
2. Balance Business Income Sources
Assess whether wages, property holdings or business legal structure changes could optimize your 199A outcomes. For some this may mean paying W-2 wages to unlock higher QBI deductions. For others it may mean shifting assets into cooperatives and REITs to have more 199A dividends.
3. Know Phase Outs and Limits
Understand how taxable income impacts eligibility at both a business activity level and your total tax return level. Plot different scenarios adjusting income and deductions to uncover more ways to stay within favorable deduction ranges.
Getting personalized guidance from a savvy tax strategist can be invaluable here!
Interpretation and Impact of Section 199a Dividends
There you have it! A complete lay of the land when it comes to Section 199A dividends.
While complex, unlocking these powerful deductions can put thousands back into your pocket each year. Whether you qualify through cooperative distributions or REIT investment income, the 20% tax break is well worth your time to understand and leverage.
Hopefully this breakdown gives you more clarity and confidence in assessing where Section 199A fits into your tax plan. Reach out to your advisor to discuss the best applications specific to your situation. Thinking through this now means taking full advantage of the tax windfall before any future uncertainty with the deduction!